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Modern Portfolio Theory Grubber - 7E-Solution PDF
Modern Portfolio Theory Grubber - 7E-Solution PDF
Chapter 1: Problem 1
A.
Opportunity Set
With one dollar, you can buy 500 red hots and no rock candies (point A),
or 100 rock candies and no red hots (point B), or any combination of red hots
and rock candies (any point along the opportunity set line AB).
then:
That is, the money spent on candies, where red hots sell for 0.2 cents a piece
and rock candy sells for 1 cent a piece, cannot exceed 100 cents ($1.00).
Solving the above equation for X gives:
X = 500 5Y
which is the equation of a straight line, with an intercept of 500 and a slope of 5.
1-1
B.
Indifference Map
Below is one indifference map. The indifference curves up and to the right
indicate greater happiness, since these curves indicate more consumption from
both candies. Each curve is negatively sloped, indicating a preference of more
to less, and each curve is convex, indicating that the rate of exchange of red
hots for rock candies decreases as more and more rock candies are consumed.
Note that the exact slopes of the indifference curves in the indifference map will
depend an the individuals utility function and may differ among students.
Chapter 1: Problem 2
A.
Opportunity Set
1-2
The individual can also choose any consumption pattern along the line AB
(the opportunity set) below.
B.
Indifference Map
We are given that the utility function of the individual is:
U(C1 , C 2 ) = 1 + C1 + C 2 +
C1C 2
50
1-3
This indifference curve appears in the graph of the indifference map below as
the curve labeled 50 (the lowest curve shown). By setting U(C1,C2) equal to 60,
we get the curve labeled 60, etc.
C.
Solution
The optimum solution is where the opportunity set is tangent to the highest
possible indifference curve (the point labeled E in the following graph).
42C1 1.1C1
U(C1 , C 2 ) = 1 + C1 + 42 1.1C1 +
50
To maximize the utility function, we take the derivative of U with respect to C1
and set it equal to zero:
dU
42 2.2C1
= 1 1.1 +
=0
dC1
50
50
which gives C1 = $16.82. Substituting $16.82 for C1 in the equation of the
opportunity set given in part A gives C2 = $23.50.
1-4
Chapter 1: Problem 3
If you consume nothing at time 1 and instead invest all of your time-1
income at a riskless rate of 10%, then at time 2 you will be able to consume all of
your time-2 income plus the proceeds earned from your investment:
$5,000 + $5,000 (1.1) = $10,500.
If you consume nothing at time 2 and instead borrow at time 1 the present value
of your time-2 income at a riskless rate of 10%, then at time 1 you will be able to
consume all of the borrowed proceeds plus your time-1 income:
$5,000 + $5,000 (1.1) = $9,545.45
All other possible optimal consumption patterns of time 1 and time 2
consumption appear on a straight line (the opportunity set) with an intercept of
$10,500 and a slope of 1.1:
C2 = $5,000 + ($5,000 C1) (1.1) = $10,500 1.1C1
Chapter 1: Problem 4
If you consume nothing at time 1 and instead invest all of your wealth plus your
time-1 income at a riskless rate of 5%, then at time 2 you will be able to consume
all of your time-2 income plus the proceeds earned from your investment:
$20,000 + ($20,000 + $50,000)(1.05) = $93,500.
1-5
If you consume nothing at time 2 and instead borrow at time 1 the present value
of your time-2 income at a riskless rate of 5%, then at time 1 you will be able to
consume all of the borrowed proceeds plus your time-1 income and your wealth:
$20,000 + $50,000 + $20,000 (1.05) = $89,047.62
All other possible optimal consumption patterns of time-1 and time-2
consumption appear on a straight line (the opportunity set) with an intercept of
$93,500 and a slope of 1.05:
C2 = $20,000 + ($20,000 + $50,000 C1) (1.05)
= $93,500 1.05C1
Chapter 1: Problem 5
With Job 1 you can consume $30 + $50 (1.05) = $82.50 at time 2 and
nothing at time 1, $50 + $30 (1.05) = $78.60 at time 1 and nothing at time 2, or
any consumption pattern of time 1 and time 2 consumption shown along the line
AB: C2 = $82.50 1.05C1.
With Job 2 you can consume $40 + $40 (1.05) = $82.00 at time 2 and
nothing at time 1, $40 + $40 (1.05) = $78.10 at time 1 and nothing at time 2, or
any consumption pattern of time 1 and time 2 consumption shown along the line
CD: C2 = $82.00 1.05C1.
The individual should select Job 1, since the opportunity set associated
with it (line AB) dominates the opportunity set of Job 2 (line CD).
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions to Text Problems: Chapter 1
1-6
Chapter 1: Problem 6
With an interest rate of 10% and income at both time 1 and time 2 of
$5,000, the opportunity set is given by the line AB:
C2 = $5,000 + ($5,000 C1) (1.1) = $10,500 1.1C1
With an interest rate of 20% and income at both time 1 and time 2 of $5,000, the
opportunity set is given by the line CD:
C2 = $5,000 + ($5,000 C1) (1.2) = $11,000 1.2C1
Chapter 1: Problem 7
For P = 50, this is simply a plot of the function C 2 =
50 C1
.
1 + C1
100 C1
.
1 + C1
1-7
Chapter 1: Problem 8
This problem is analogous to Problem 2. We present the analytical solution
below. The problem could be solved graphically, as in Problem 2.
From Problem 3, the opportunity set is C2 = $10,500 1.1C1. Substituting this
equation into the preference function P = C1 + C2 + C1 C2 yields:
P = C1 + $10,500 1.1C1 + $10,500C1 1.1C12
dP
= 1 1.1 + $10,500 2.2C1 = 0
dC1
C1 = $4,772.68
C2 = $5,250.05
Chapter 1: Problem 9
Let X = the number of pizza slices, and let Y = the number of hamburgers.
Then, if pizza slices are $2 each, hamburgers are $2.50 each, and you have $10,
your opportunity set is given algebraically by
$2X + $2.50Y = $10
Solving the above equation for X gives X = 5 1.25Y, which is the equation for a
straight line with an intercept of 5 and a slope of 1.25.
Graphically, the opportunity set appears as follows:
Assuming you like both pizza and hamburgers, your indifference curves will
be negatively sloped, and you will be better off on an indifference curve to the
right of another indifference curve. Assuming diminishing marginal rate of
substitution between pizza slices and hamburgers (the lower the number of
hamburgers you have, the more pizza slices you need to give up one more burger
without changing your level of satisfaction), your indifference curves will also be
convex.
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions to Text Problems: Chapter 1
1-8
A typical family of indifference curves appears below. Although you would rather
be on an indifference curve as far to the right as possible, you are constrained by
your $10 budget to be on an indifference curve that is on or to the left of the
opportunity set. Therefore, your optimal choice is the combination of pizza slices
and hamburgers that is represented by the point where your indifference curve is
just tangent to the opportunity set (point A below).
Chapter 1: Problem 10
If you consume C1 at time 1 and invest (lend) the rest of your time-1 income at 5%,
your time-2 consumption (C2) will be $50 from your time-2 income plus ($50
C1)(1.05) from your investment. Algebraically, the opportunity set is thus
C2 = 50 + (50 - C1)(1.05) = 102.50 - 1.05C1
If C1 is 0 (no time-1 consumption), then from the above equation C2 will be
$102.50. If C2 is 0, then C1 will be $97.62. Graphically, the opportunity set appears
below, along with a typical family of indifference curves.
1-9
Chapter 1: Problem 11
If you consume C1 at time 1 and invest (lend) the rest of your time-1 income
at 20%, your time-2 consumption (C2) will be $10,000 from your time-2 income plus
$10,000 from your inheritance plus ($10,000 - C1)(1.20) from your investment. The
opportunity set is thus
C2 = $10,000 + $10,000 + ($10,000 - C1)(1.20) = $32,000 - 1.2C1
If C2 is 0 (no time-2 consumption), then you can borrow the present value of your
time-2 income and your time-2 inheritance and spend that amount along with
your time-1 income on time-1 consumption. Solving the above equation for C1
when C2 is 0 gives C1 = $26,666.67, which is the maximum that can be consumed
at time 1. Similarly, if C1 is 0 (no time-1 consumption), then you can invest all of your
time-1 income at 20% and spend the future value of your time-1 income plus your
time-2 income and inheritance on time-2 consumption. From the above equation,
C2 will be $32,000 when C1 is 0, which is the maximum that can be consumed at
time 2.
Chapter 1: Problem 12
If you consume nothing at time 2, then you can borrow the present value of
your time-2 income for consumption at time 1. If the borrowing rate is 10% and
your time-2 income is $100, then the present value (at time 1) of your time-2
income is $100/(1.1) = $90.91. You can borrow this amount and spend it along with
your time- income of $100 on time-1 consumption. So the maximum you can
consume at time 1 is $90.91 + $100 = $190.91. If you consume nothing at time 1
and instead invest all of your time-1 income of $100 at the lending rate of 5%, the
future value (in period 2) of your period 1 income will be $100(1.05) = $105. You
can then spend that amount along with your time 2 income of $100 on time-2
consumption. So the maximum you can consume at time 2 is $105 + $100 = $205.
With two different interest rates, we have two separate equations for opportunity
sets: one for borrowers and one for lenders.
If you only consume some of your time 1 income at time 1 and invest the
rest at 5%, you have the following opportunity set: C2 = 100 + (100 - C1)(1.05) = 205 1.05C1. If you only consume some of your time-2 income at time 2 and borrow the
present value of the rest at 10% for consumption at time 1, your opportunity set is:
C1 = 100 + (100 - C2)/(1.1) = 190.91 - C2/1.1,or, solving the equation for C2,
C2 = 210 - 1.1C1
1-10
The lines intersect at point E (which represents your income endowment for times 1
and 2). Moving along the lines above point E represents lending (investing some
time-1 income); moving along the lines below point E represents borrowing
(spending more than your time-1 income on time-1 consumption). Since you can
only lend at 5%, line segment AE represents your opportunity set if you choose to
lend. Since you must borrow at 10%, line segment ED represents your opportunity
set if you choose to borrow. So your total opportunity set is represented by AED.
1-11
8
4
12
0
2
4
2
6
0
3
12
6
18
0
4
0
0
0
10.7
4
= 1.
2.83 1.41
1
1
1
0
2
1
1
1
0
3
1
1
1
0
4
0
0
0
1
4-1
C.
Portfolio
Expected Return
13%
12%
10%
13%
10.67%
12.67%
Portfolio
Variance
12.5
4.6
6.7
4-2
Chapter 4: Problem 2
A.
B.
Monthly Returns
Security
Month
3
4
3.7%
0.4%
-6.5% 1.4%
6.2%
2.1%
10.5% 0.5%
3.7%
3.4%
-1.4%
1.4%
16.9%
1.0%
RA =
RB = 2.95%
RC = 7.92%
C.
A =
(3.7% 1.22% )2 + (0.4% 1.22% )2 + ( 6.5% 1.22% )2 + (1.4% 1.22% )2 + (6.2% 1.22% )2 + (2.1% 1.22% )2
6
= 15.34 = 3.92%
B = 14.42 = 3.8%
C = 46.02 = 6.78%
4-3
D.
AB
(3.7% 1.22% ) (10.5% 2.95% ) + (0.4% 1.22% ) (0.5% 2.95% ) + ( 6.5% 1.22% ) (3.7% 2.95% )
+ (1.4% 1.22% ) (1.0% 2.95% ) + (6.2% 1.22% ) (3.4% 2.95% ) + (2.1% 1.22% ) ( 1.4% 2.95% )
=
6
= 2.17
AC = 7.24 ; BC = 19.89
AB =
2.17
= 0.15
3.92 3.8
AC = 0.27 ; BC = 0.77
E.
P1 =
(1/ 2)2 15.34 + (1/ 2)2 14.42 + 02 46.02 + 2 (1/ 2 1/ 2 2.17 + 1/ 2 0 7.24 + 1/ 2 0 19.89)
= 8.53 = 2.92%
P 2 = 18.96 = 4.35%
Portfolio 3 (X1 = 0; X2= 1/2; X3= 1/2):
RP 3 = 5.44%
P3 = 5.17 = 2.27%
Portfolio 4 (X1 = 1/3; X2= 1/3; X3= 1/3):
RP 4 = 4.03%
P 4 = 6.09 = 2.47%
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 4
4-4
Chapter 4: Problem 3
It is shown in the text below Table 4.8 that a formula for the variance of an
equally weighted portfolio (where Xi = 1/N for i = 1, , N securities) is
2
2
P =1/N j kj + kj
18
10
14
20
12
50
10.8
100
10.4
Chapter 4: Problem 4
As is shown in the text, as the number of securities (N) approaches infinity, an
equally weighted portfolios variance (total risk) approaches a minimum equal
to the average covariance of the pairs of securities in the portfolio, which in
Problem 3 is given as 10. Therefore, 10% above the minimum risk level would result
in the portfolios variance being equal to 11. Setting the formula shown in the
above answer to Problem 3 equal to 11 and using 2j = 50 and kj = 10 we have:
P2 = 1/ N (50 10 ) + 10 = 11
Solving the above equation for N gives N = 40 securities.
4-5
Chapter 4: Problem 5
As shown in the text, if the portfolio contains only one security, then the portfolios
average variance is equal to the average variance across all securities, 2j . If
instead an equally weighted portfolio contains a very large number of securities,
then its variance will be approximately equal to the average covariance of the
pairs of securities in the portfolio, kj . Therefore, the fraction of risk that of an
individual security that can be eliminated by holding a large portfolio is expressed
by the following ratio:
i2 kj
i2
From Table 4.9, the above ratio is equal to 0.6 (60%) for Italian securities and 0.8
(80%) for Belgian securities. Setting the above ratio equal to those values and
solving for kj gives kj = 0.4 i2 for Italian securities and kj = 0.2 i2 for Belgian
securities.
Thus, the ratio
i2 0.2 i2
0.2 i2
i2 kj
kj
equals
i2 0.4 i2
0.4 i2
= 1.5
If the average variance of a single security, 2j , in each country equals 50, then
Belgian P2
26
18
20
21.5
12
100
20.3
10.4
4-6
Chapter 4: Problem 6
The formula for an equally weighted portfolio's variance that appears below Table
4.8 in the text is
2
2
P =1/N j kj + kj
N = 41.997.
Since the portfolio's variance decreases as N increases, holding 42 securities will
provide a variance less than 8, so 42 is the minimum number of securities that will
provide a portfolio variance less than 8.
4-7
R 1 = 12%
R 2 = 6%
R 3 = 14%
R 4 = 12%
21 = 8
22 = 2
23 = 18
24 = 10.7
1 = 2.83%
2 = 1.41%
3 = 4.24%
4 = 3.27%
12 = 4
13 = 12
14 = 0
23 = 6
24 = 0
34 = 0
12 = 1
13 = 1
14 = 0
23 = 1.0
24 = 0
34 = 0
In this problem, we will examine 2-asset portfolios consisting of the following pairs
of securities:
Pair
Securities
A
B
C
D
E
F
1 and 2
1 and 3
1 and 4
2 and 3
2 and 4
3 and 4
A.
Short Selling Not Allowed
(Note that the answers to part A.4 are integrated with the answers to parts A.1,
A.2 and A.3 below.)
A.1
We want to find the weights, the standard deviation and the expected return of
the minimum-risk porfolio, also known as the global minimum variance (GMV)
portfolio, of a pair of assets when short sales are not allowed.
5-1
We further know that the compostion of the GMV portfolio of any two assets i
and j is:
X iGMV =
j2 ij
i2 + j2 2 ij
X GMV
= 1 X iGMV
j
22 12
2 (4)
6
1
=
=
(or 33.33%)
=
2
2
1 + 2 2 12 8 + 2 (2)(4) 18 3
X 2GMV = 1 X1GMV = 1
1 2
=
(or 66.67%)
3 3
This in turn gives the following for the GMV portfolio of Pair A:
R GMV =
1
3
1
2
12% + 6% = 8%
3
3
2
3
1 2
3 3
2
GMV
= (8 ) + (2 ) + (2 ) ( 4 ) = 0
GMV = 0
Recalling that 12 = 1, the above result demonstrates the fact that, when two
assets are perfectly negatively correlated, the minimum-risk portfolio of those two
assets will have zero risk.
Pair B (assets 1 and 3):
Applying the above GMV weight formula to Pair B yields the following weights:
X1GMV = 3 (300%) and X 3GMV = 2 (200%)
This means that the GMV portfolio of assets 1 and 3 involves short selling asset 3.
But if short sales are not allowed, as is the case in this part of Problem 1, then the
GMV portfolio involves placing all of your funds in the lower risk security (asset
1) and none in the higher risk security (asset 3). This is obvious since, because the
correlation between assets 1 and 3 is +1.0, portfolio risk is simply a linear
combination of the risks of the two assets, and the lowest value that can be
obtained is the risk of asset 1.
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 5
5-2
Thus, when short sales are not allowed, we have for Pair B:
X1GMV = 1 (100%) and X 3GMV = 0 (0%)
2
R GMV = R1 = 12% ; GMV
= 12 = 8 ; GMV = 1 = 2.83%
0.572
0.428
12%
2.14%
D (i = 2, j = 3)
0.75
0.25
8%
0%
E (i = 2, j = 4)
0.8425
0.1575
6.95%
1.3%
F (i = 3, j = 4)
0.3728
0.6272
12.75%
2.59%
5-3
Pair B
Pair C
5-4
Pair D
Pair E
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security 4.
5-5
Pair F
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security 3.
B.
Short Selling Allowed
(Note that the answers to part B.4 are integrated with the answers to parts B.1,
B.2 and B.3 below.)
B.1
When short selling is allowed, all of the GMV portfolios shown in Part A.1 above
are the same except the one for Pair B (assets 1 and 3). In the no-short-sales case
in Part A.1, the GMV portfolio for Pair B was the lower risk asset 1 alone.
However, applying the GMV weight formula to Pair B yielded the following
weights:
X1GMV = 3 (300%) and X 3GMV = 2 (200%)
This means that the GMV portfolio of assets 1 and 3 involves short selling asset 3 in
an amount equal to twice the investors original wealth and then placing the
original wealth plus the proceeds from the short sale into asset 1. This yields the
following for Pair B when short sales are allowed:
R GMV = 3 12% 2 14% = 8%
2
GMV
= (3 ) (8 ) + ( 2 ) (18) + (2 )(3 )( 2 )(12) = 0
GMV = 0
2
Recalling that 13 = +1, this demonstrates the fact that, when two assets are
perfectly positively correlated and short sales are allowed, the GMV portfolio of
those two assets will have zero risk.
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 5
5-6
The efficient set is the positively sloped line segment through security 1 and out
toward infinity.
Pair B
5-7
Pair C
The efficient set is the positively sloped line segment through security 3 and out
toward infinity.
5-8
Pair E
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security 4 toward infinity.
Pair F
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security 3 toward infinity.
5-9
C.
Pair A (assets 1 and 2):
Since the GMV portfolio of assets 1 and 2 has an expected return of 8% and a risk
of 0%, then, if riskless borrowing and lending at 5% existed, one would borrow an
infinite amount of money at 5% and place it in the GMV portfolio. This would be
pure arbitrage (zero risk, zero net investment and positive return of 3%). With an
8% riskless lending and borrowing rate, one would hold the same portfolio one
would hold without riskless lending and borrowing. (The particular portfolio held
would be on the efficient frontier and would depend on the investors degree of
risk aversion.)
Pair B (assets 1 and 3):
Since short sales are allowed in Part C and since we saw in Part B that when short
sales are allowed the GMV portfolio of assets 1 and 3 has an expected return of
8% and a risk of 0%, the answer is the same as that above for Pair A.
Pair C (assets 1 and 4):
We have seen that, regardless of the availability of short sales, the efficient
frontier for this pair of assets was a single point representing the GMV portfolio,
with a return of 12%. With riskless lending and borrowing at either 5% or 8%, the
new efficient frontier (efficient set) will be a straight line extending from the
vertical axis at the riskless rate and through the GMV portfolio and out to infinity.
The amount that is invested in the GMV portfolio and the amount that is
borrowed or lent will depend on the investors degree of risk aversion.
Pair D (assets 2 and 3):
Since assets 2 and 3 are perfectly negatively correlated and have a GMV
portfolio with an expected return of 8% and a risk of 0%, the answer is identical to
that above for Pair A.
Pair E (assets 2 and 4):
We arrived at the following answer graphically; the analytical solution to this
problem is presented in the subsequent chapter (Chapter 6). With a riskless rate
of 5%, the new efficient frontier (efficient set) will be a straight line extending from
the vertical axis at the riskless rate, passing through the portfolio where the line is
tangent to the upper half of the original portfolio possibilities curve, and then out
to infinity. The amount that is invested in the tangent portfolio and the amount
that is borrowed or lent will depend on the investors degree of risk aversion. The
tangent portfolio has an expected return of 9.4% and a standard deviation of
1.95%. With a riskless rate of 8%, the point of tangency occurs at infinity.
5-10
R B = 2.95%
R C = 7.92%
2A = 15.34
2B = 14.42
2C = 46.02
A = 3.92%
B = 3.8%
C = 6.78%
AB = 2.17
AC = 7.24
BC = 19.89
AB = 0.15
AC = 0.27
BC = 0.77
In this problem, we will examine 2-asset portfolios consisting of the following pairs
of securities:
Pair
Securities
1
2
3
A and B
A and C
B and C
5-11
A.
Short Selling Not Allowed
(Note that the answers to part A.4 are integrated with the answers to parts A.1,
A.2 and A.3 below.)
A.1
We want to find the weights, the standard deviation and the expected return of
the minimum-risk porfolio, also known as the global minimum variance (GMV)
portfolio, of a pair of assets when short sales are not allowed.
We further know that the compostion of the GMV portfolio of any two assets i
and j is:
X iGMV
j2 ij
i2 + j2 2 ij
X GMV
= 1 X iGMV
j
B2 AB
2
A
2
B
2 AB
14.42 2.17
= 0.482 (or 48.2%)
15.34 + 14.42 (2)(2.17)
This in turn gives the following for the GMV portfolio of Pair 1:
R GMV = 0.482 1.22% + 0.518 2.95% = 2.12%
2
GMV
= (0.482) (15.34 ) + (0.518) (14.42 ) + (2 )(0.482)(0.518)(2.17) = 8.52
2
GMV = 2.92%
5-12
0.827
0.173
2.38%
3.73%
3 (i = B, j = C)
0.658
0.342
4.65%
1.63%
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security B.
5-13
Pair 2
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security C.
Pair 3
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security C.
5-14
B.
Short Selling Not Allowed
(Note that the answers to part B.4 are integrated with the answers to parts B.1,
B.2 and B.3 below.)
B.1
When short selling is allowed, all of the GMV portfolios shown in Part A.1 above
remain the same.
B.2 and B.3
When short selling is allowed, the portfolio possibilities graphs are extended.
Pair 1
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security B toward infinity.
5-15
Pair 2
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security C toward infinity.
Pair 3
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security C toward infinity.
5-16
C.
In all cases where the riskless rate of either 5% or 8% is higher than the returns on
both of the individual securities, if short sales are not allowed, any rational
investor would only invest in the riskless asset. Even if short selling is allowed, the
point of tangency of a line connecting the riskless asset to the original portfolio
possibilities curve occurs at infinity for all cases, since the original GMV portfolios
return is lower than 5% in all cases.
Chapter 5: Problem 3
The answers to this problem are given in the answers to part A.1 of Problem 2.
Chapter 5: Problem 4
The locations, in expected return standard deviation space, of all portfolios
composed entirely of two securities that are perfectly negatively correlated (say,
security C and security S) are described by the equations for two straight lines, one
with a positive slope and one with a negative slope. To derive those equations,
start with the expressions for a two-asset portfolio's standard deviation when the
two assets' correlation is 1 (the equations in (5.8) in the text), and solve for XC (the
investment weight for security C). E.g., for the first equation:
P = X C C (1 X C ) S
P = XC C - S + XC S
P + S = X C ( C + S )
P + S .
XC =
C + S
Now plug the above expression for XC into the expression for a two-asset portfolio's
expected return and simplify:
RP = X C RC + (1 X C )RS
+
+
= P S RC + 1 P S RS
C + S
C + S
+
= RS + P RC S RC P RS S RS
C + S
= RS + RC RS S + RC RS P .
C + S C + S
The above equation is that of a straight line in expected return standard deviation
space, with an intercept equal to the first term in brackets and a slope equal to
the second term in brackets.
5-17
P = X C C + (1 X C ) S
P = XC C + S XC S
P S = X C ( C + S )
S P .
XC =
C + S
Substitute the above expression for XC into the equation for expected return and
simplify:
RP = X C RC + (1 X C )RS
= S P RC + 1 S P RS
C + S
C + S
+
= RS + S RC P RC S RS P RS
C + S
= RS + RC RS S + RS RC P .
C + S C + S
The above equation is also that of a straight line in expected return standard
deviation space, with an intercept equal to the first term in brackets and a slope
equal to the second term in brackets. The intercept term for the above equation is
identical to the intercept term for the first derived equation. The slope term is
equal to 1 times the slope term of the first derived equation. So when one
equation has a positive slope, the other equation has a negative slope (when the
expected returns of the two assets are equal, the two lines are coincident), and
both lines meet at the same intercept.
Chapter 5: Problem 5
When equals 1, the least risky "combination" of securities 1 and 2 is security 2 held
alone (assuming no short sales). This requires X1 = 0 and X2 = 1, where the X's are
the investment weights. The standard deviation of this "combination" is equal to
the standard deviation of security 2; P = 2 = 2.
When equals -1, we saw in Chapter 5 that we can always find a combination of
the two securities that will completely eliminate risk, and we saw that this
combination can be found by solving X1 = 2/(1 + 2). So, X1 = 2/(5 + 2) = 2/7, and
since the investment weights must sum to 1, X2 = 1 - X1 = 1 - 2/7 = 5/7. So a
combination of 2/7 invested in security 1 and 5/7 invested in security 2 will
completely eliminate risk when equals -1, and P will equal 0.
5-18
25
4
25 + 4
29
29
P =
=
400 2500
+
841
841
2900
841
= 1.86%
=
Chapter 5: Problem 6
If the riskless rate is 10%, then the risk-free asset dominates both risky assets in terms
of risk and return, since it offers as much or higher expected return than either risky
asset does, for zero risk. Assuming the investor prefers more to less and is risk averse,
the optimal investment is the risk-free asset.
5-19
6-1
The optimum portfolio solutions using Lintner short sales and the given values for RF
are:
Z1
Z2
Z3
RF = 6%
3.510067
1.043624
0.348993
RF = 8%
1.852348
0.526845
0.214765
RF = 10%
0.194631
0.010070
0.080537
X1
X2
X3
0.715950
0.212870
0.711800
0.714100
0.203100
0.082790
0.682350
0.035290
0.282350
6.105%
6.419%
11.812%
0.737%
0.802%
2.971%
Chapter 6: Problem 3
Since short sales are not allowed, this problem must be solved as a quadratic
programming problem. The formulation of the problem is:
RP RF
max =
subject to:
N
=1
i =1
Xi 0 i
6-2
Chapter 6: Problem 4
This problem is most easily solved using The Investment Portfolio software that
comes with the text, but, since all pairs of assets are assumed to have the same
correlation coefficient of 0.5, the problem can also be solved manually using the
constant correlation form of the Elton, Gruber and Padberg Simple Techniques
described in a later chapter.
To use the software, open up the Markowitz module, select file then new then
group constant correlation to open up a constant correlation table. Enter the
input data into the appropriate cells by first double clicking on the cell to make it
active. Once the input data have been entered, click on optimizer and then
run optimizer (or simply click on the optimizer icon). At that point, you can either
select full Markowitz or simple method.
If you select full Markowitz, you then select short sales allowed/riskless lending
and borrowing and then enter 4 for both the lending and borrowing rate and
click OK. A graph of the efficient frontier then appears. You may then hit the
Tab key to jump to the tangent portfolio, then click on optimizer and then
show portfolio (or simply click on the show portfolio icon) to view and print the
composition (investment weights), mean return and standard deviation of the
tangent (optimum) portfolio.
If instead you select simple method, you then select short sales allowed with
riskless asset and enter 4 for the riskless rate and click OK. A table showing the
investment weights of the tangent portfolio then appears.
Regardless of the method used, the resulting investment weights for the optimum
portfolio are as follows:
Asset i
1
2
3
4
5
6
7
8
9
10
Xi
5.999%
17.966%
21.676%
0.478%
29.585%
12.693%
59.170%
14.793%
3.442%
189.224%
6-3
Given the above weights, the optimum (tangent) portfolio has a mean return of
18.907% and a standard deviation of 3.297%. The efficient frontier is a positively
sloped straight line starting at the riskless rate of 4% and extending through the
tangent portfolio (T) and out to infinity:
Chapter 6: Problem 5
Since the given portfolios, A and B, are on the efficient frontier, the GMV portfolio
can be obtained by finding the minimum-risk combination of the two portfolios:
X AGMV =
B2 AB
2
A
2
B
2 AB
16 20
1
=
36 + 16 2 20
3
X BGMV = 1 X AGMV = 1
1
3
Also, since the two portfolios are on the efficient frontier, the entire efficient frontier
can then be traced by using various combinations of the two portfolios, starting
with the GMV portfolio and moving up along the efficient frontier (increasing the
weight in portfolio A and decreasing the weight in portfolio B). Since XB = 1 XA
the efficient frontier equations are:
RP = X A R A + (1 X A )R B = 10 X A + 8 (1 X A )
P = X A2 A2 + (1 X A ) B2 + 2 X A (1 X A ) AB
2
= 36X A2 + 16(1 X A ) + 40 X A (1 X A )
2
6-4
Since short sales are allowed, the efficient frontier will extend beyond portfolio A
and out toward infinity. The efficient frontier appears as follows:
6-5
RA =
At
t =1
12
12.05 + 15.27 4.12 + 1.57 + 3.16 2.79 8.97 1.18 + 1.07 + 12.75 + 7.48 0.94
=
12
= 2.946%
The sample mean monthly return on the market portfolio (the answer to part 1.E) is:
12
mt
Rm =
t =1
12
12.28 + 5.99 + 2.41 + 4.48 + 4.41 + 4.43 6.77 2.11 + 3.46 + 6.16 + 2.47 1.15
=
12
= 3.005%
Using data given in the problem and the above two sample mean monthly
returns, we have the following:
Month t
1
2
3
4
5
6
7
8
9
10
11
12
Sum
RAt RA
9.104
12.324
-7.066
-1.376
0.214
-5.736
-11.916
-4.126
-1.876
9.804
4.534
-3.886
0.00
(R
RA
82.883
151.881
49.928
1.893
0.046
32.902
141.991
17.024
3.519
96.118
20.557
15.101
Rmt Rm
9.275
2.985
-0.595
1.475
1.405
1.425
-9.775
-5.115
0.455
3.155
-0.535
-4.155
613.84
0.00
At
(R
Rm
86.026
8.910
0.354
2.176
1.974
2.031
95.551
26.163
0.207
9.954
0.286
17.264
mt
250.90
(R
At
)(
RA Rmt Rm
84.44
36.79
4.2
-2.03
0.3
-8.17
116.48
21.1
-0.85
30.93
-2.43
16.15
296.91
7-1
The sample variance and standard deviation of the stock As monthly return are:
(R
12
A2 =
RA
At
t =1
12
613.84
= 51.15
12
A = 51.15 = 7.15%
The sample variance (the answer to part 1.F) and standard deviation of the
market portfolios monthly return are:
(R
12
2
m
=
mt
Rm
t =1
12
250.90
= 20.91
12
m = 20.91 = 4.57%
The sample covariance of the returns on stock A and the market portfolio is:
[(R
12
Am =
At
)(
RA Rmt Rm
t =1
12
)]
=
296.91
= 24.74
12
The sample correlation coefficient of the returns on stock A and the market
portfolio (the answer to part 1.D) is:
Am =
24.74
Am
=
= 0.757
7
.
15
4.57
A m
A =
Am 24.74
=
= 1.183
2
20.91
m
7-2
RAt
Month t
1
2
3
4
5
6
7
8
9
10
11
12
RA,t,Pr edicted
12.05
15.27
-4.12
1.57
3.16
-2.79
-8.97
-1.18
1.07
12.75
7.48
-0.94
13.92
6.48
2.24
4.69
4.61
4.63
-8.62
-3.11
3.48
6.68
2.31
-1.97
Sum:
At
-1.87
8.79
-6.36
-3.12
-1.45
-7.42
-0.35
1.93
-2.41
6.07
5.17
1.02
0.00
2
At
3.5
77.26
40.45
9.73
2.1
55.06
0.12
3.72
5.81
36.84
26.73
1.04
262.36
Since the sample residuals sum to 0 (because of the way the sample alpha and
beta are calculated), the sample mean of the sample residuals also equals 0 and
the sample variance and standard deviation of the sample residuals (the answer
to part 1.C) are:
(
12
2A =
At
t =1
12
)
12
t =1
12
At
262.36
= 21.863
12
A = 21.863 = 4.676%
7-3
Repeating the above analysis for all the stocks in the problem yields:
Stock A
Stock B
Stock C
0.609%
2.964%
3.422%
beta
1.183
1.021
2.322
correlation
with market
0.757
0.684
0.652
4.676%
4.983%
12.341%
alpha
standard deviation
of sample residuals*
2
= 20.91.
with R m = 3.005% and m
that most regression programs use N 2 for the denominator in the sample
residual variance formula and use N 1 for the denominator in the other variance
formulas (where N is the number of time series observations). As is explained in the
text, we have instead used N for the denominator in all the variance formulas. To
convert the variance from a regression program to our results, simply multiply the
N2
N 1
or
.
variance by either
N
N
*Note
Chapter 7: Problem 2
A.
A.1
The Sharpe single-index model's formula for a security's mean return is
Ri = i + i R m
Using the alpha and beta for stock A along with the mean return on the market
portfolio from Problem 1 we have:
R A = 0.609 + 1.183 3.005 = 2.946%
Similarly:
R B = 6.032% ; RC = 3.556%
7-4
The Sharpe single-index model's formula for a security's variance of return is:
2
i2 = i2 m
+ 2i
Using the beta and residual standard deviation for stock A along with the variance
of return on the market portfolio from Problem 1 we have:
b2 = 46.62 ; c2 = 265.0
A.2
From Problem 1 we have:
Using the betas for stocks A and B along with the variance of the market portfolio
from Problem 1 we have:
SIM AB = 1.183 1.021 20.91 = 25.254
Similarly:
SIM AC = 57.433 ; SIM BC = 49.568
7-5
B.2
The formula for sample covariance from the historical time series of 12 pairs of
returns on security i and security j is:
(R
12
ij =
it
)(
Ri Rjt Rj
t =1
12
Applying the above formula to the monthly data given in Problem 1 for securities
A, B and C gives:
1
1
1
2.946% + 6.032% + 3.556% = 4.18%
3
3
3
2
2
2
2
2
1 2
1
1
1
1
1
3
3
3
3
3
= 8.348%
C.2
Using the earlier results from the historical data, the mean monthly return and
standard deviation of an equally weighted portfolio of stocks A, B and C are:
RP =
1
1
1
2.946% + 6.031% + 3.554% = 4.18%
3
3
3
1
3
1
3
1
3
1 2
1
3
1
3
= 8.374%
7-6
D.
The slight differences between the answers to parts A.1 and A.2 are simply due to
rounding errors. The results for sample mean return and variance from either the
Sharpe single-index model formulas or the sample-statistics formulas are in fact
identical.
The answers to parts B.1 and B.2 differ for sample covariance because the Sharpe
single-index model assumes the covariance between the residual returns of
securities i and j is 0 (cov(i j ) = 0), and so the single-index form of sample
covariance of total returns is calculated by setting the sample covariance of the
sample residuals equal to 0. The sample-statistics form of sample covariance of
total returns incorporates the actual sample covariance of the sample residuals.
The answers in parts C.1 and C.2 for mean returns on an equally weighted portfolio
of stocks A, B and C are identical because the Sharpe single-index model formula
for the mean return on an individual stock yields a result identical to that of the
sample-statistics formula for the mean return on the stock.
The answers in parts C.1 and C.2 for standard deviations of return on an equally
weighted portfolio of stocks A, B and C are different because the Sharpe singleindex model formula for the sample covariance of returns on a pair of stocks yields
a result different from that of the sample-statistics formula for the sample
covariance of returns on a pair of stocks.
Chapter 7: Problem 3
Recall from the text that the Vasicek techniques forecast of security is beta ( i 2 )
is:
i2 =
2i1
21 + 2i1
1 +
21
21 + 2i1
i1
where 1 is the average beta across all sample securities in the historical period (in
this problem referred to as the market beta), i1 is the beta of security i in the
historical period, 21 is the variance of all the sample securities betas in the
historical period and 2i1 is the square of the standard error of the estimate of beta
for security i in the historical period.
If the standard errors of the estimates of all the betas of the sample securities in the
historical period are the same, then, for each security i, we have:
2i1 = a
where a is a constant across all the sample securities.
7-7
i2 =
21 + a
1 +
21
21 + a
i1 = X 1 + (1 X ) i1
This shows that, under the assumption that the standard errors of all historical betas
are the same, the forecasted beta for any security using the Vasicek technique is
a simple weighted average (proportional weighting) of 1 (the market beta)
and i1 (the securitys historical beta), where the weights are the same for each
security.
Chapter 7: Problem 4
Letting the historical period of the year of monthly returns given in Problem 1 equal
1 (t = 1), then the forecast period equals 2 and the Blume forecast equation is:
i 2 = 0.41 + 0.60 i1
Using the earlier answer to Problem 1 for the estimate of beta from the historical
period for stock A along with the above equation we obtain the stocks
forecasted beta:
B 2 = 1.023 ; C2 = 1.803
Chapter 7: Problem 5
A.
The single-index model's formula for security i's mean return is
Ri = i + i Rm
7-8
Similarly:
RB = 13.4% ; RC = 7.4% ; RD = 11.2%
B.
The single-index model's formula for security i's own variance is:
2 2
2
2
i = i m + ei .
A = A m + eA
= (1.5) (5) + (3 )
2
= 65.25
Similarly:
2B = 43.25; 2C = 20; 2D = 36.25
C.
The single-index model's formula for the covariance of security i with security j is
2
ij = ji = i j m
Since 2m = 25, then, e.g., for securities A and B we have:
2
AB = A B m
= 1.5 1.3 25
= 48.75
Similarly:
AC = 30; AD = 33.75; BC = 26; BD = 29.25; CD = 18
Chapter 7: Problem 6
A.
Recall that the formula for a portfolio's beta is:
N
P = Xi i
i =1
The weight for each asset (Xi) in an equally weighted portfolio is simply 1/N, where
N is the number of assets in the portfolio.
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 7
7-9
Since there are four assets in Problem 5, N = 4 and Xi equals 1/4 for each asset in
an equally weighted portfolio of those assets. So:
1
1
1
1
A + B + C + D
4
4
4
4
1
= (1.5 + 1.3 + 0.8 + 0.9)
4
1
= 4.5
4
= 1.125
P =
B.
Recall that the definition of a portfolio's alpha is:
P =
X
i
i =1
P =
C.
Recall that a formula for a portfolios variance using the single-index model is:
N
2
P2 = P2 m
+ Xi2 e2i
i =1
P2
1
1
1
1
= (1.125) (5) + (3)2 + (1)2 + (2)2 + (4)2
4
4
4
4
1
= (1.125)2 25 + (9 + 1 + 4 + 16)
16
= 33.52
2
7-10
D.
Using the single-index models formula for a portfolios mean return we have:
RP = P + P Rm
= 2.5 + 1.125 8
= 11.5%
Chapter 7: Problem 7
Using i 2 = 0.343 + 0.677 i1 and the historical betas given in Problem 5 we can
forecast, e.g., the beta for security A:
A2 = 0.343 + 0.677 A1
= 0.343 + 0.677 1.5
= 0.343 + 1.0155
= 1.3585
Similarly:
A2 =
=
21
2A1
+
A1
1
21 + 2A1
21 + 2A1
(0.21)2
(0.25)2
+
1.5
1
(0.25)2 + (0.21)2
(0.25)2 + (0.21)2
0.0625
0.0441
1+
1.5
0.0625 + 0.0441
0.0625 + 0.0441
= 0.4137 1 + 0.5863 1.5
= 0.4137 + 0.8795
= 1.2932
Similarly:
7-11
7-12
im jm
2
2 m
2
m
m
2
= im 2i m jm 2j m m
m
m
= im jm i j
=
If the assumptions of both the constant correlation and single-index model hold,
then we have CC ij = SIM ij :
* i j = im jm i j or * = im jm
This must hold for all pairs of securities, including i and j, i and k and j and k. So we
have:
* = im jm
* = im km
* = jm km
The only solution to the above set of equations is:
im = jm = km = *
Therefore, for any security i we have:
i =
*
im im i m im i
=
=
=
i
2
2
m
m
m
m
In other words, given that all pairs of securities have the same correlation
coefficient and that the Sharpe single-index model holds, each securitys beta is
proportional to its standard deviation, where the proportion is a constant across all
securities equal to
*
.
m
8-1
Chapter 8: Problem 2
Start with a general 3-index model of the form:
(1)
I 2* = 0 + 1 I1 + d t or I2 = dt = I2* ( 0 + 1 I1)
which gives:
I2* = 0 + 1 I1 + I2
Substituting the above expression into equation (1) and rearranging we get:
) (
The first term in the above equation is a constant, which we can define as a1 . The
coefficient in the second term of the above equation is also a constant, which we
can define as bi1 . We can then rewrite the above equation as:
(2)
I3* = 0 + 1 I1 + 2 I2 + et or I 3 = et = I 3* ( 0 + 1 I1 + 2 I 2 )
which gives:
I 3* = 0 + 1 I1 + 2 I 2 + I 3
Substituting the above expression into equation (2) and rearranging we get:
In the above equation, the first term and all the coefficients of the new orthogonal
indices are constants, so we can rewrite the equation as:
Ri = ai + bi1 I1 + bi 2 I2 + bi 3 I3 + ci
8-2
Chapter 8: Problem 3
Recall from the earlier chapter on the single-index model that an expression for
the covariance of returns on two securities i and j is:
[(
)]
[ (
)]
2
ij = i j E Rm Rm + j E ei Rm Rm + i E ej Rm Rm + E[ei ej ]
The first term contains the variance of the market portfolio, the second two terms
contain the covariance of the market portfolio with the residuals and the last term
is the covariance of the residuals.
Given that one of the models assumptions is that the covariance of the market
portfolio with the residuals is zero and that, from the problem, the covariance of
the residuals equals a constant K, the derived covariance between the two
securities is:
2
ij = i j m
+K
i =1
j =1 k =1
k j
P2 = Xi2 i2 + X j Xk jk
Recalling that the single-index models expression for the variance of a security is
2
i2 = i2 m
+ ei2 and substituting that expression and the derived expression for
covariance into the above equation and rearranging gives:
N
i =1
i =1
j =1 k =1
k j
2
2
P2 = Xi2 i2 m
+ Xi2 ei2 + X j Xk j k m
+ X j Xk K
2
Xi X j i j m
+
i =1 j =1
i =1
2
P
2
m
Xi2 ei2 +
i =1
Xi i
2
Xi i m
+
i =1
i =1
Xi2
2
ei
+ K
X X K
j
j =1 k =1
k j
j =1 k =1
k j
Xi2 ei2 +
i =1
X X K
j
j =1 k =1
k j
X j Xk
k =1
k j
j =1
8-3
Chapter 8: Problem 4
Using the result from Problem 2, we have:
Ri = ai + bi1 I1 + bi 2 I2 + bi 3 I3 + ci
Since the residual ci always has a mean of zero (by construction if necessary), we
have the following expression for expected return:
R i = a i + b i1 I1 + b i 2 I 2 + b i 3 I 3
(
= E (b (I I ) + b (I
i2 = E ai + bi1 I1 + bi 2 I2 + bi 3 I3 + ci ai + bi1 I1 + bi 2 I2 + bi 3 I3
i1 1
i2 2
) )
))
2
2
I2 + bi 3 I3 I3 + ci
Carrying out the squaring, noting that the indices are all orthogonal with each
other and making the usual assumption that the residual is uncorrelated with any
index gives us:
i2 = bi21 I21 + bi22 I22 + bi23 I23 + ci2
ai + bi1 I1 + bi 2 I2 + bi 3 I3 + ci ai + bi1 I1 + bi 2 I2 + bi 3 I3
))
a j + b j1 I1 + b j 2 I2 + b j 3 I3 + c j a j + b j1 I1 + b j 2 I2 + b j 3 I3
i2 = E
[( (
) ( (
))
= E bi1 I1 I1 + bi 2 I2 I2 + bi 3 I3 I3 + ci b j1 I1 I1 + b j 2 I2 I2 + b j 3 I3 I3 + c j
)]
Carrying out the multiplication, noting that the indices are all orthogonal with
each other, making the usual assumption that the residuals are uncorrelated with
any index and assuming that the residuals are uncorrelated with each other gives
us:
ij = bi1b j1 I21 + bi 2 b j 2 I22 + bi 3 b j 3 I23
8-4
Chapter 8: Problem 5
The formula for a security's expected return using a general two-index model is:
Ri = ai + bi1 I1 + bi 2 I 2
Using the above formula and data given in the problem, the expected return for,
e.g., security A is:
R A = a A + b A1 I1 + b A2 I 2
= 2 + 0.8 8 + 0.9 4
= 12%
Similarly:
RB = 17% ; RC = 12.6%
8-5
Chapter 8: Problem 6
For an industry-index model, the text gives two formulas for the covariance
between securities i and k. If firms i and k are both in industry j, the covariance
between their securities' returns is given by:
2
ik = bim bkm m
+ bij bkj Ij2
Otherwise, if the firms are in different industries, the covariance of their securities'
returns is given by:
2
ik = bim bkm m
2
BC = bBm bCm m
= (1.1)(0.9)(2 ) = 3.96
2
Chapter 8: Problem 7
The answers for this problem are found in the same way as the answers for problem 6,
except that now only firms B and C are in the same industry. So for firms B and C, the
covariance between their securities' returns is:
2
+ bB2 bC2 I22
BC = bBm bCm m
8-6
The other formula should be used for the other pairs of firms:
2
AB = b Am bBm m
2
AC = b Am bCm m
Chapter 8: Problem 8
To answer this problem, use the procedure described in Appendix A of the text.
First, I1 is defined as being equal to I*1 , then I*2 is regressed on I1 to obtain the given
regression equation. Since dt is uncorrelated with I1 by the techniques of regression
analysis, dt is an orthogonal index to I1. So, define I2 = dt. Then express the given
regression equation as:
I*2 = 1 + 1.3 I1 + I2.
Now, substitute the above equation for I*2 into the given multi-index model and
simplify:
Ri
The two-index model has now been transformed into one with orthogonal indices
I1 and I2, where I1 = I*1, and I2 = dt = I*2 - 1 - 1.3 I1.
8-7
1
2
3
4
5
6
Ri RF
Ri RF
10
9
7
4
3
6
i
10.0000
6.0000
4.6667
4.0000
3.7500
3.0000
(R R )
i
ei2
0.3333
1.3500
0.5250
0.2000
0.2400
0.3000
i2
ei2
0.0333
0.2250
0.1125
0.0500
0.0640
0.1000
R j RF j
ej2
j =1
0.3333
1.6833
2.2083
2.4083
2.6483
2.9483
i
j2
j =1 ej
0.0333
0.2583
0.3708
0.4208
0.4848
0.5848
i
Ci
2.5000
4.6980
4.6910
4.6242
4.5286
4.3053
The numbers in the column above labeled Ci were obtained by recalling from the
text that, if the Sharpe single-index model holds:
Ci =
R j RF j
ej
j =1
2
i j
2
1+ m
j =1 2
ej
i
2
m
2
Thus, given that m
= 10:
C1 =
10 0.3333
3.333
=
= 2.500
1+ 10 0.0333 1.333
C2 =
10 1.6833
16.833
=
= 4.698
1+ 10 0.2583 3.583
etc.
Ri RF
> C i . Thus,
only securities 1 and 6 (the highest and second highest ranked securities in the
above table) are in the optimal (tangent) portfolio. We could have stopped our
R RF
calculations after the first time we found a ranked security for which i
< Ci ,
(in this case the third highest ranked security, security 2), but we did not so that we
R RF
could demonstrate that i
< C i for all of the remaining lower ranked securities
as well.
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 9
9-1
Since security 6 (the second highest ranked security, where i = 2) is the last ranked
R RF
> C i , we set C* = C2 = 4.698 and
security in descending order for which i
solve for the optimum portfolios weights using the following formulas:
Z i = 2i
ei
Ri RF
C*
Xi =
Zi
2
i =1
1
Z1 = (10 4.698) = 0.1767
30
1.5
Z2 =
(6 4.698) = 0.1953
10
0.1767
= 0.475
0.3720
X2 =
0.1953
= 0.525
0.3720
Since i = 1 for security 1 and i = 2 for security 6, the optimum (tangent) portfolio
when short sales are not allowed consists of 47.5% invested in security 1 and 52.5%
invested in security 6.
Chapter 9: Problem 2
This problem uses the same input data as Problem 1. When short sales are allowed,
all securities are included and C* is equal to the value of Ci for the lowest ranked
security. Referring back to the table given in the answer to Problem 1, we see that
the lowest ranked security is security 3, where i = 6. Therefore, we have C* = C6 =
4.3053.
9-2
To solve for the optimum portfolios weights, we use the following formulas:
Z i = 2i
ei
Ri RF
C*
and
Xi =
Zi
i =1
or
Xi =
Zi
i =1
So we have:
1
Z1 = (10 4.3053) = 0.1898
30
1.5
Z2 =
(6 4.3053) = 0.2542
10
1.5
Z3 =
(4.667 4.3053) = 0.0271
20
1
Z 4 = (4 4.3053) = 0.0153
20
0.8
Z5 =
(3.75 4.3053) = 0.0444
10
2.0
Z6 =
(3 4.3053) = 0.0653
40
i =1
i =1
9-3
This gives us the following weights (by rank order) for the optimum portfolios under
either the standard definition of short sales or the Lintner definition of short sales:
Standard Definition
Lintner Definition
Security 1 (i = 1)
X1 =
0.1898
= 0.5484
0.3461
X1 =
0.1898
= 0.3184
0.5961
Security 6 (i = 2)
X2 =
0.2542
= 0.7345
0.3461
X2 =
0.2542
= 0.4264
0.5961
Security 2 (i = 3)
X3 =
0.0271
= 0.0783
0.3461
X3 =
0.0271
= 0.0455
0.5961
Security 5 (i = 4)
X4 =
0.0153
= 0.0442
0.3461
X4 =
0.0153
= 0.0257
0.5961
Security 4 (i = 5)
X5 =
0.0444
= 0.1283
0.3461
X5 =
0.0444
= 0.0745
0.5961
Security 3 (i = 6)
X6 =
0.0653
= 0.1887
0.3461
X6 =
0.0653
= 0.1095
0.5961
Chapter 9: Problem 3
With short sales allowed but no riskless lending or borrowing, the optimum portfolio
depends on the investors utility function and will be found at a point along the
upper half of the minimum-variance frontier of risky assets, which is the efficient
frontier when riskless lending and borrowing do not exist. As is described in the text,
the entire efficient frontier of risky assets can be delineated with various
combinations of any two efficient portfolios on the frontier. One such efficient
portfolio was found in Problem 2. By simply solving Problem 2 using a different
value for RF , another portfolio on the efficient frontier can be found and then the
entire efficient frontier can be traced using combinations of those two efficient
portfolios.
9-4
Chapter 9: Problem 4
In the table below, given that the riskless rate equals 5%, the securities are ranked
in descending order by their excess return over standard deviation.
Security
1
2
5
6
4
3
7
Rank i
Ri R F
1
2
3
4
5
6
7
10
15
5
9
7
13
11
Ri RF
R j RF
j
j =1
1.00
2.00
3.00
3.90
4.60
5.25
5.80
i
1.00
1.00
1.00
0.90
0.70
0.65
0.55
1 + i
Ci
0.5000
0.3333
0.2500
0.2000
0.1667
0.1429
0.1250
0.5000
0.6667
0.7500
0.7800
0.7668
0.7502
0.7250
The numbers in the column above labeled Ci were obtained by recalling from the
text that, if the constant-correlation model holds:
C i =
1 + i
R j RF
j
j =1
i
Ri RF
> C i . Thus,
only securities 1, 2, 5 and 6 (the four highest ranked securities in the above table)
are in the optimal (tangent) portfolio. We could have stopped our calculations
R RF
after the first time we found a ranked security for which i
< C i , (in this case
the fifth highest ranked security, security 4), but we did not so that we could
R RF
demonstrate that i
< C i for all of the remaining lower ranked securities as
well.
9-5
Since security 6 (the fourth highest ranked security, where i = 4) is the last ranked
R RF
security in descending order for which i
> C i , we set C* = C4 = 0.78 and solve
1
Z i =
(1 ) i
Ri RF
C*
Xi =
Zi
4
i =1
1
(1 0.78 ) = 0.0440
Z1 =
(0.5)(10 )
1
(1 0.78) = 0.0293
Z 2 =
(0.5)(15)
1
(1 0.78) = 0.0880
Z 3 =
(0.5)(5)
1
(0.9 0.78 ) = 0.0240
Z 4 =
(0.5)(10 )
Z1 + Z 2 + Z 3 + Z 4 = 0.0440 + 0.0293 + 0.0880 + 0.0240 = 0.1853
X1 =
0.0440
= 0.2375
0.1853
X2 =
0.0293
= 0.1581
0.1853
X3 =
0.0880
= 0.4749
0.1853
X4 =
0.0240
= 0.1295
0.1853
Since i = 1 for security 1, i = 2 for security 2, i = 3 for security 5 and i = 4 for security 6,
the optimum (tangent) portfolio when short sales are not allowed consists of
23.75% invested in security 1, 15.81% % invested in security 2, 47.49% % invested in
security 5 and 12.95% invested in security 6.
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 9
9-6
Chapter 9: Problem 5
This problem uses the same input data as Problem 4. When short sales are allowed,
all securities are included and C* is equal to the value of Ci for the lowest ranked
security. Referring back to the table given in the answer to Problem 4, we see that
the lowest ranked security is security 7, where i = 7. Therefore, we have C* = C7 =
0.725.
To solve for the optimum portfolios weights, we use the following formulas:
1
Z i =
(1 ) i
Ri RF
C*
and
Xi =
Zi
i =1
or
Xi =
Zi
i =1
So we have:
1
(1 0.725) = 0.0550
Z1 =
(0.5)(10 )
1
(1 0.725) = 0.0367
Z 2 =
(0.5)(15)
1
(1 0.725) = 0.1100
Z 3 =
(0.5)(5)
1
(0.9 0.725) = 0.0350
Z 4 =
(0.5)(10 )
1
(0.7 0.725) = 0.0050
Z 5 =
(0.5)(10 )
1
(0.65 0.725) = 0.0075
Z 6 =
(0.5)(20 )
1
(0.55 0.725) = 0.0175
Z 7 =
(0.5)(20 )
7
i =1
i =1
9-7
This gives us the following weights (by rank order) for the optimum portfolios under
either the standard definition of short sales or the Lintner definition of short sales:
Standard Definition
Lintner Definition
Security 1 (i = 1)
X1 =
0.0550
= 0.2661
0.2067
X1 =
0.0550
= 0.2062
0.2667
Security 2 (i = 2)
X2 =
0.0367
= 0.1776
0.2067
X2 =
0.0367
= 0.1376
0.2667
Security 5 (i = 3)
X3 =
0.1100
= 0.5322
0.2067
X3 =
0.1100
= 0.4124
0.2667
Security 6 (i = 4)
X4 =
0.0350
= 0.1703
0.2067
X4 =
0.0350
= 0.1312
0.2667
Security 4 (i = 5)
X5 =
0.0050
= 0.0242
0.2067
X5 =
0.0050
= 0.0187
0.2667
Security 3 (i = 6)
X6 =
0.0075
= 0.0363
0.2067
X6 =
0.0075
= 0.0281
0.2667
Security 7 (i = 7)
X7 =
0.0175
= 0.0847
0.2067
X7 =
0.0175
= 0.0656
0.2667
Chapter 9: Problem 6
With short sales allowed but no riskless lending or borrowing, the optimum portfolio
depends on the investors utility function and will be found at a point along the
upper half of the minimum-variance frontier of risky assets, which is the efficient
frontier when riskless lending and borrowing do not exist. As is described in the text,
the entire efficient frontier of risky assets can be delineated with various
combinations of any two efficient portfolios on the frontier. One such efficient
portfolio was found in Problem 5. By simply solving Problem 5 using a different
value for RF , another portfolio on the efficient frontier can be found and then the
entire efficient frontier can be traced using combinations of those two efficient
portfolios.
9-8
11-1
Solving for X:
X = 0.61
Therefore, the first outcomes probability of 0.5 would have to be increased by
0.11 to 0.61, and the second outcomes probability of 0.25 would have to be
reduced by 0.11 to 0.14.
Chapter 11: Problem 5
The investor will prefer the investment that maximizes expected utility of terminal
wealth. Recall that the formula for expected utility of wealth (E[U(W)]) is:
E[U(W )] =
U(W ) P(W )
W
where each P(W) is the probability associated with each particular outcome of
wealth (W). Since U(W ) = W 0.05W 2 , we have:
Investment A:
11-2
The equation above is a quadratic equation with two roots. Using the quadratic
formula, the roots are found to be 6.26 and 13.74. So, the minimum amount that
the first outcome of investment A would have to change by for the investor to be
indifferent between investments A and B would be $6.26 $5 = $1.26 (an
increase), since both investments would then provide the same level of expected
utility.
Chapter 11: Problem 7
Roys safety-first criterion is to minimize Prob(RP < RL). If RL = 5%, then (assuming an
initial investment of $100) for the outcomes in Problem 1 we have:
Prob(RA < 5%) = 0.0
Prob(RB < 5%) = 0.25
Prob(RC < 5%) = 0.20
Thus, using Roys safety-first criterion, investment in A is preferred over investments
in B and C, and investment in C is preferred over investment in B.
Chapter 11: Problem 8
Kataoka's safety-first criterion is to maximize RL subject to Prob(RP < RL) . If =
10%, then (assuming an initial investment of $100) for the outcomes in Problem 1
the maximum RL is:
4.99% for A
3.99% for B
0.99% for C
Thus, A is preferred to B and C, and B is preferred to C.
Chapter 11: Problem 9
Employing Telser's criterion, we see that (assuming an initial investment of $100)
Projects A, B and C in Problem 1 do not satisfy the constraint Prob(Rp 5%) 10%.
So, investments A, B, and C are indistinguishable using Telsers criterion with RL = 5%.
11-3
11-4
>
RUS RF
US
N,US
As is explained in the text, if the above inequality holds, then the foreign
investment will be attractive to a U.S. investor. RUS and RN for the foreign
countries are given in the problem's table. From the tables in the text, we have:
Austria
France
Japan
U.K.
N,US
24.50
17.76
25.70
15.59
0.281
0.534
0.348
0.646
Also, from the text tables, US = 13.59. Given that RF = 6%, we have:
Austria
France
Japan
U.K.
RN RF
RUS RF
US
0.327
0.563
0.311
0.577
0.289
0.550
0.358
0.665
N,US
For Austria and France, the above inequality holds, so a U.S. investor should
consider those foreign markets as attractive investments; for Japan and the U.K.,
the above inequality does not hold, so a U.S. investor should not consider those
foreign markets as attractive investments.
12-1
22 1 2 12
12 + 22 2 1 2 12
2
(
16.7) (13.59)(16.7)(0.423)
=
(13.59)2 + (16.7)2 (2)(13.59)(16.7)(0.423)
= 0.6734 (67.34% )
GMV
X NGMV = 1 X US
= 0.3266 (32.66% )
For bonds, US = 7.90, N = 9.45 and N,US = 0.527. So the minimum-risk portfolio is:
(9.45)2 (7.9)(9.45)(0.527)
(7.9)2 + (9.45)2 (2)(7.9)(9.45)(0.527)
= 0.6841 (68.41% )
GMV
X US
=
GMV
X NGMV = 1 X US
= 0.3159 (31.59% )
For T-bills, US = 0.35, N = 6.77 and N,US = 0.220. So the minimum-risk portfolio is:
GMV
X US
=
GMV
X NGMV = 1 X US
= 0.0137 (1.37% )
12-2
(1 + RX)
(for US investor)
2.5/3 = 0.833
2.5/2.5 = 1.000
2/2.5 = 0.800
1.5/2 = 0.750
2.5/1.5 = 1.667
(1 + R*X)
(for UK investor)
3/2.5 = 1.200
2.5/2.5 = 1.000
2.5/2 = 1.250
2/1.5 = 1.333
1.5/2.5 = 0.600
The total return to a U.S. investor from a U.K. investment is (1 + RX)(1 + RUK) 1; the
total return to a U.K. investor from a U.S. investment is(1 + R*X)(1 + RUS) 1. So:
Return to U.S. Investor
Period
1
2
3
4
5
Average
From U.S.
Investment
10%
15%
5%
12%
6%
1
1
1
1
1
=
=
=
=
=
7.6%
12.5%
5.0%
8.0%
19.0%
83.3%
7.76%
Return to U.K. Investor
Period
1
2
3
4
5
Average
From U.K.
Investment
5%
5%
15%
8%
10%
6.6%
1
1
1
1
1
=
=
=
=
=
32.0%
15.0%
18.75%
49.3%
36.4%
15.73%
12-3
US =
= 6.95%
UK =
= 38.06%
For U.K. Investor
UK =
= 6.65%
US =
(32 15.73)2 + (15 15.73)2 + (18.75 15.73)2 + (49.3 15.73)2 + ( 36.4 15.73)2
5
= 28.70%
Period
1
2
3
4
5
(1 + RX)
(for US investor)
200/180 = 1.111
180/190 = 0.947
190/150 = 1.267
150/170 = 0.882
170/180 = 0.944
(1 + R*X)
(for Japanese investor)
180/200 = 0.900
190/180 = 1.056
150/190 = 0.789
170/150 = 1.133
180/170 = 1.059
12-4
The total return to a U.S. investor from a Japan investment is (1 + RX)(1 + RJ) 1; the
total return to a Japanese investor from a U.S. investment is(1 + R*X)(1 + RUS) 1. So:
Return to U.S. Investor
Period
1
2
3
4
5
Average
From U.S.
Investment
12%
15%
5%
10%
6%
1
1
1
1
1
=
=
=
=
=
31.10%
6.06%
39.37%
1.22%
1.01%
15.26%
9.6%
Return to Japanese Investor
Period
1
2
3
4
5
Average
From Japan
Investment
18%
12%
10%
12%
7%
11.8%
1
1
1
1
1
=
=
=
=
=
0.80%
21.44%
17.16%
24.63%
12.25%
8.39%
12-5
(R
5
t =1
(R
5
t =1
USt
USt
)(
RUS R Jt R J
RUS
) (R
2
t =1
Jt
RJ
12-6
Ri = RF + Rm RF i
Thus, from the data in the problem we have:
If the expected return on either stock is higher than its return given above, the
stock is a good buy.
Chapter 13: Problem 3
Given the security market line in this problem, the two funds expected returns
would be:
R A = 0.06 + 0.19 0.8 = 0.212 (21.2% )
RB = 0.06 + 0.19 1.2 = 0.288 (28.8% )
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 13
13-1
Comparing the above returns to the funds actual returns, we see that both funds
performed poorly, since their actual returns were below those expected given
their beta risk.
Chapter 13: Problem 4
Given the security market line in this problem, the riskless rate equals 0.04 (4%), the
intercept of the line, and the excess return of the market above the riskless rate
(also called the market risk premium) equals 0.10 (10%), the slope of the line.
(The return on the market portfolio must therefore be 0.04 + 0.10 = 0.14, or 14%.)
Chapter 13: Problem 5
The price form of the CAPMs security market line equation is:
Pi =
1
rF
cov (Yi Ym )
Yi Ym rF Pm
var (Ym )
Ym Pm
.
Pm
Ym Pm
Pm
cov (Yi Ym )
1
Yi (1.14 Pm 1.04 Pm )
1.04
var (Ym )
cov (Yi Ym )
1
Yi 0.10 Pm
1.04
var (Ym )
13-2
(1)
X i Ui = 0
(2)
Xi 0
(3)
Ui 0
(4)
We have already seen that, given the assumptions of the standard CAPM, setting
d
= 0 gives the equilibrium first order condition for asset i, which is the standard
dX i
CAPMs security market line:
Ri = RF + R m RF i
or equivalently
Ri RF Rm RF i = 0
When short sales are not allowed, Kuhn-Tucker condition (1) implies that:
Ri RF Rm RF i + Ui = 0
But, since all assets are held long in the market portfolio, Xi > 0 for each asset and
therefore, given Kuhn-Tucker condition (2), Ui = 0 for each asset. Thus, the standard
CAPM holds even if short sales are not allowed.
13-3
Ri = RF + R m RF i
Substituting the given values for assets 1 and 2 gives two equations with two
unknowns:
9.4 = RF + R m RF 0.8
13.4 = RF + R m RF 1.3
Solving simultaneously gives:
RF = 3% ; Rm = 11%
13-4
RZ has the same role in the zero-beta model as RF does in the standard model. So,
referring back to the answer to Problem 5 in Chapter 13, simply replace RF with RZ
to obtain:
Pi =
cov (Yi Ym )
1
Yi Ym rZ Pm
var (Ym )
rZ
where rZ = 1+ R Z .
Ri = RF + Rm RF ( m RF ) i + ( i RF )
Ri = RF (1 ) + Rm RF ( m RF ) i + i
Comparing the above general equation to the specific one given in the problem,
0.05
, and that = 0.24 . Therefore:
we see that RF (1 ) = 0.05 , or RF =
(1 )
RF =
0.05
= 0.0658 (6.58% )
(1 0.24)
14-1
Since both M and Z are on the minimum-variance curve, the entire minimumvariance curve of risky assets can be traced out by using combinations (portfolios)
of M and Z. Letting X be the investment weight for the market portfolio, the
expected return on any combination portfolio P of M and Z is:
R P = X R m + (1 X )R Z
(1)
P = X 2 m2 + (1 X ) Z2
2
(2)
14-2
Substituting the given values for R m and R Z into equation (1) gives:
R P = 15 X + 5(1 X )
= 10 X + 5
(3)
Substituting the given values for m and Z into equation (2) gives:
P = X 2 22 2 + (1 X ) 8 2
2
= 484 X 2 + 64 128 X + 64 X 2
(4)
= 548 X 2 128 X + 64
Using equations (3) and (4) and varying X (the fraction invested in the market
portfolio M) gives various coordinates for the minimum-variance curve; some of
them are given below:
X
0.2
0.4
0.6
0.8
1.0
1.5
2.0
RP
11
13
15
20
25
7.77
33.24 44.72
The zero-beta form of the security market line describes equilibrium beta risk and
expected return relationship for all securities and portfolios (including portfolio L)
except those combination portfolios composed of the riskless asset and tangent
portfolio L along the ray RF - L in the above graph:
Ri = RZ + Rm RZ i
= 5 + 10 i
The equilibrium beta risk and expected return relationship for any combination
portfolio C composed of the riskless asset and tangent portfolio L along the ray
RF - L in the above graph is described by the following line:
R C = RF +
(R
RF
14-3
((
R i = RF + R m RF ( m RF ) i + ( i RF )
If the standard CAPM model holds, then:
R i = RF + R m RF i
Assume that the post-tax model holds instead of the standard model, and
m = RF .
For a stock with ( i RF ) > 0 , the institution that uses the post-tax model would
correctly believe that the stock has a higher expected return than the stocks
return expected by the institution using the standard model. Similarly, for a stock
with ( i RF ) < 0 , the institution that uses the post-tax model would correctly
believe the stock has a lower expected return than the stocks return expected by
the institution using the standard model.
14-4
Now consider a specific example using the following data for stocks A and B, the
market portfolio and the riskless asset:
14-5
ARB
i
1= 0
(1)
a ARB =
ARB
ai
i
=0
(2)
ARB
bi
i
=0
(3)
b ARB =
Since the above portfolio has zero net investment and zero risk with respect to the
given two-factor model, by the force of arbitrage its expected return must also be
zero:
R ARB =
ARB
Ri
i
=0
(4)
From a theorem of linear algebra, since the above orthogonality conditions (1), (2)
and (3) with respect to the X iARB result in orthogonality condition (4) with respect to
the X iARB , R i can be expressed as a linear combination of 1, ai and bi:
R i = 0 1+ 1ai + 2 bi
(5)
Z
i
=1
aZ =
Z
i ai
=0
Z
i bi
=0
bZ =
Z
i Ri
= 0
X
i
Z
i
+ 1
X
i
Z
i ai
+ 2
Z
i bi
= 0
14-6
M
i
=1
aM =
M
i ai
=1
bM =
M
i bi
=0
M
i Ri
= 0
M
i
+ 1
M
i ai
+ 2
M
i bi
= 0 + 1
or
1 = R M 0 = R M R Z
We can create a strictly interest rate-risk investment portfolio as follows:
C
i
=1
aC =
C
i ai
=0
C
i bi
=1
bC =
C
i Ri
= 0
C
i
+ 1
C
i ai
+ 2
C
i bi
= 0 + 2
or
2 = R C 0 = R C R Z
Substituting the derived values for 0, 1 and 2 into equation (5), we have:
R i = R Z + R M R Z ai + R C R Z b i
14-7
14-8
The zero-beta security market line is the line in the graph below extend from the
expected return on a zero-beta asset through the market portfolio and out toward
infinity (assuming unlimited short sales). The expected return-beta relationships of
all risky securities risky-asset portfolios (including the market portfolio M and
portfolio L) are described by that line. The other line from the risk-free lending rate
to portfolio L only describes the expected return-beta relationships of combination
portfolios of the risk-free asset and portfolio L; those combination portfolios are not
described by the zero-beta security market line.
14-9
2
m
R m RF
P
cov (Ri Rm ) + H cov (Ri RH )
P
Pm
+ H cov (Rm RH )
Pm
14-10
R Ai = R G + R P R G
cov (R Ai RP )
var (RP )
The above equation is exactly parallel to the zero-beta CAPM equation, with
expected percentage change in alcoholism in a city playing the role of the
expected return on a security. The analogy between variables is seen from:
Ri = RZ + Rm RZ
cov (Ri Rm )
var (Rm )
Therefore, tests exactly parallel to those employed in the text can be used.
15-1
15-2
(a)
13.4 0 31 0.2 2
(b)
12 0 31 0.5 2
(c)
The above set of linear equations can be solved simultaneously for the three
unknown values of 0, 1 and 2. There are many ways to solve a set of
simultaneous linear equations. One method is shown below.
Subtract equation (a) from equation (b):
1.4 21 0.32
(d)
(e)
Assuming the derived equilibrium APT plane holds, since portfolio D has bD1 = 2 and
bD2 = 0 with an expected return of 10%, the portfolio is not in equilibrium and an
arbitrage opportunity exists.
The first step is to use portfolios in equilibrium to create a replicating equilibrium
investment portfolio, call it portfolio E, that has the same factor loadings (risk) as
portfolio D. Using the equilibrium portfolios A, B and C in Problem 1 and recalling
that an investment portfolios weights sum to 1 and that a portfolios factor
loadings are weighted averages of the individual factor loadings we have:
bE1 X A b A1 X B b B1 1 X A X B bC1 1X A 3 X B 31 X A X B bD1 2
X A 0.7X B
Since X A
1
2
1
2
1
1
, X B 0 and X C 1 X A X B .
2
2
1
1
12 0 13.4 12 12%
2
2
So now we have two portfolios with exactly the same risk: the target portfolio D
and the equilibrium replicating portfolio E. Since they have the same risk (factor
loadings), we can create an arbitrage portfolio, combining the two portfolios by
going long in one and shorting the other. This will create a self-financing (zero net
investment) portfolio with zero risk: an arbitrage portfolio.
ARB
i
ARB
i
b ARB1
1
1
0 1 0 (zero net investment)
2
2
ARB
b i1
i
ARB
bi 2
i
ARB
Ri
i
(a)
13 0 1.51 22
(b)
17 0 0.51 3 2
(c)
Solving for the three unknowns in the same way as in Problem 1, we obtain the
following solution to the above set of simultaneous linear equations:
0 8 ; 1 6 ; 2 2 ;
Thus, the equation of the equilibrium APT plane is:
R i 8 6b i1 2b i 2
Assuming the derived equilibrium APT plane holds, since portfolio D has bD1 = 1 and
bD2 = 0 with an expected return of 15%, the portfolio is not in equilibrium and an
arbitrage opportunity exists.
The first step is to use portfolios in equilibrium to create a replicating equilibrium
investment portfolio, call it portfolio E, that has the same factor loadings (risk) as
portfolio D. Using the equilibrium portfolios A, B and C in Problem 3 and recalling
that an investment portfolios weights sum to 1 and that a portfolios factor
loadings are weighted averages of the individual factor loadings we have:
bE1 X A b A1 X B bB1 1 X A X B b C1 1X A 1.5 X B 0.51 X A X B bD1 1
bE 2 X A b A2 X B b B2 1 X A X B bC 2 X A 2 X B 31 X A X B b D2 0
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
4 X A 5X B 3
1
1
1
, X B and X C 1 X A X B .
3
3
3
1
1
1
12 13 17 14%
3
3
3
So now we have two portfolios with exactly the same risk: the target portfolio D
and the equilibrium replicating portfolio E. Since they have the same risk (factor
loadings), we can create an arbitrage portfolio, combining the two portfolios by
going long in one and shorting the other. This will create a self-financing (zero net
investment) portfolio with zero risk: an arbitrage portfolio. In equilibrium, an
arbitrage portfolio has an expected return of zero, but since portfolio D is not in
equilibrium, neither is the arbitrage portfolio containing D and E, and an arbitrage
profit may be made.
We need to short sell either portfolio D or E and go long in the other. The question
is: which portfolio do we short and which do we go long in? Since both portfolios
have the same risk and since portfolio D has a higher expected return than
portfolio E, we want to go long in D and short E; in other words, we want X DARB 1
and X EARB 1. This gives us:
ARB
i
ARB
i
b ARB1
1 1 1
1 0 (zero net investment)
3 3 3
ARB
b i1
i
ARB
bi 2
i
ARB
Ri
i
R i 0
b
k
ik
k 1
Given the data in the problem and in Table 16.1 in the text, along with a riskless
rate of 8%, the Sharpe multi-factor model for the expected return on a stock in the
construction industry is:
R i 8 5.36 1.2 0.24 6 5.56 0.4 0.12 0.2 2 1 1.59
10.034%
The last number, 1.59, enters because the stock is a construction stock.
Problem 1, we have:
1 4 1 or 1 0.25 ; 2 4 2 or 2 0.5 .
B.
From the text we know that i bi1 1 bi 2 2 . So we have:
R A Rf R m RF A or RF R A R m RF A
RF 12 4 0.5 10%
17-1
17-2
D (1+ g)
D1
0.55 1.1
=
= $15.13
= 0
0.14 0.10
kg
kg
P0 =
D1
1
=
= $20.00
k rb 0.12 0.14 0.5
D1
1
+ rb =
+ 0.14 0.5 = 0.103 (10.3% )
P0
30
D 1
1 1
= 0.207 (20.7% )
r = k 1 = 0.12
60 0.5
P0 b
So the rate of return on new investment would have to change from 14% to 20.7%,
an increase of 6.7 percentage points.
18-1
P0 =
D1(1+ g1 )
(1+ k)
t =1
t 1
D1(1+ g1 )
(1+ k)
t =1
t 1
P5
(1+ k )5
D6
k g2
+
(1+ k )5
1+ g 5 D6
1
1
+
1
k
k g2
= D1
+
k g1
(1+ k )5
1+ g 5 D6
1
1
1+ k k g2
= D0 (1+ g1 )
+
k g1
(1+ k )5
Recognizing that the dividend at the end of period 6 is equal to the dividend at
the end of period 5 compounded 1 period at g2 and then adjusted by a factor of
0.5/0.3 to reflect the increased dividend payout rate, we have:
D6 = D5 (1+ g2 )
0.5
0.3
0.5
0.3
0.5
5
= 0.55 (1.1) 1.06
0.3
= $1.565
= D0 (1+ g1 ) (1+ g2 )
5
18-2
So we have:
1.1 5 1.565
1
P0 = 0.55 1.1
+
0.14 0.10
(1.14)5
0.16355 19.563
= 0.605
+
0.04
1.925
= 2.474 + 10.163
= $12.64
t
k g1
(1+ k )9
t =6 (1+ k )
t 4
1+ g 5
1
(1+ g j ) D10
1
9 D5
k gS
1+ k
j =2
+
= D1
+
t
k g1
(1+ k )
(1+ k )9
t =6
t 4
1+ g 5
5
1
(1+ g j )
(
)
1
+
D
g
1
9 0
1
j =2
1+ k
+
+
= D0 (1+ g1 )
k g1 t =6
(1+ k )t
D10
k gS
(1+ k )9
18-3
Recognizing that the dividend at the end of period 10 is equal to the dividend at
the end of period 9 compounded 1 period at gS and then adjusted by a factor of
0.5/0.3 to reflect the increased dividend payout rate, we have:
D10 = D9 (1+ g S )
0.5
0.3
= D0 (1+ g1 )
5
0.5
(1+ g ) (1+ g ) 0.3
j
j =2
0.5
0.3
= $2.129
So we have:
t 4
1+ g 5
5
1
(1+ g j ) D10
(
)
+
D
g
1
1
9 0
1
k g6
1+ k
j =2
+
+
P0 = D0 (1+ g1 )
t
k g1
(1+ k )
(1+ k )9
t =6
1.1 5
1
5
5
1.14 0.55 (1.1) 1.092 0.55 (1.1) 1.092 1.084
= 0.55 1.1
+
+
0.14 0.10
(1.14)6
(1.14)7
(1.14)8
(1.14)9
2.129
0.14 0.06
+
(1.14)9
= 2.474 + 0.441+ 0.419 + 0.396 + 0.371+ 8.184
= $12.29
D1
1
+ rb = + 0.14 0.5 = 0.181 (18.1% )
P0
9
18-4
D (1+ g)
D1
+g
+g= 0
P0
P0
0.55 1.1
+ 0.1
9
= 0.167 (16.7% )
D11
k g2
(1+ k )10
= D1(1+ g1 ) (1+ g2 )
9
= 1 (1.07) 1.05
9
= $1.93
So we have:
1.07 10
1.93
P0 = 1
+
0.12 0.07
(1.12)10
= 7.33 + 8.88
= $16.21
18-5
1+ g N1
1
1
N + N
PN1+ N2
1+ k 1 2 Dt
+
+
P0 = D0 (1+ g1 )
N1+ N2
t
k g1
t = N1+1 (1+ k ) (1+ k )
N2
1+ g N1
(g gS ) DN1+ N2 +1
N1
1
1+ g1 j 1
1
N1+ N2 D0 (1+ g1 )
(N2 + 1) k gS
1+ k
j =1
= D0 (1+ g1 )
+
t
N +N
k g1
(
)
1
+
k
(1+ k ) 1 2
=
+
t
N
1
1
where
D0 = the just-paid dividend
g1 = the annual growth rate during the first period of years
N1 = the number of years in the first growth period
N2 = the number of years in the second growth period of linearly changing growth
rates
gS = the annual steady-state growth rate after the second period of linearly
changing growth rates
Note that the step value for linearly changing rates from g1 to gS is
(g1 gS) / (N2 + 1), not (g1 gS) / N2.
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 18
18-6
Et = Et 1 + a Et Et 1
where
Et = the time-t forecast for earnings at time t + 1;
Et = the actual earnings at time t;
a = a constant less than 1.0.
B.
If earnings follow a mean-reverting process with a trend but no cycle, either
smoothed earnings plus the trend or smoothed earnings times the trend could be
used, depending on whether the trend was additive or multiplicative. For
example, with an additive trend the forecast would be:
t
Et + g
where
) [
)]
t 1 + a Et Et 1 + g
t 1 ;
Et = Et 1 + g
(E
t ft
+g
19-1
19-2
t = 2:
Solving the above two equations simultaneously gives YA= YB = 1/2. So buying 1/2
of bond A and 1/2 of bond B gives the same cash flows as buying 1 bond C (or,
equivalently, buying 1 bond A and 1 bond B gives the same cash flows as buying
2 of bond C). Therefore, if the Law of One Price held, the bonds current prices
would be related as follows:
1/2 PA + 1/2 PB = PC
But, since we are given that PA = $970, PB = $936 and PC = $980, we have instead:
1/2 $970 + 1/2 $936 = $953 < $980
The Law of One Price does not hold.
Given that the future cash flows of the portfolio of bonds A and B are identical in
timing and amount to those of bond C, and assuming that all three bonds are in
the same risk class, an investor should purchase 1 bond A and 1 bond B rather
than 2 of bond C.
Chapter 21: Problem 2
A.
A bonds current yield is simply its annual interest payment divided by its current
price, so we have:
Current Yield = $100 $960 = 0.1042 (10.42%)
21-1
B.
A bonds yield to maturity is the discount rate that makes the sum of the present
values of the bonds future cash flows equal to the bonds current price. Since this
bond has annual cash flows, we need to find the rate, y, that solves the following
equation:
5
$100 + $1000
$960 =
(1+ y )t (1+ y )5
t =1
We can find y iteratively by trial and error, but the easiest way is to use a financial
calculator and input the following:
PV = 960
PMT = 100
FV = 1000
N=5
After entering the above data, compute I to get I = y = 11.08%.
Chapter 21: Problem 3
In general, the nominally annualized spot rate for period t (S0t) is the yield to
maturity for a t-period zero-coupon (pure discount) instrument:
P0 =
F
S0t
1+
where P0 is the zeros current market price, F is the zeros face (par) value, and t
is the number of semi-annual periods left until the zero matures.
The zero-coupon bonds in this problem all have face values equal to $1,000.
21-2
960 =
920 =
885 =
855 =
1000
S01
1+
1000
S02
1+
1000
S03
1+
1000
S04
1+
2
The nominally annualized implied forward rates (ft,t+j) can be obtained from the
above spot rates. A general expression for the relationship between current spot
rates and implied forward rates is:
ft ,t + j
S0,t + j
1+
2
1+ S0,t
2
t+ j
1 2
where t is the semi-annual period at the end of which the forward rate begins, j is
the number of semi-annual periods spanned by the forward rate, and both t and
j are integers greater than 0.
21-3
f12
f23
f34
S 2
1+ 02
(1.0426)2
2 = 0.0870 (8.70%)
=
1
2
1
1
1
(
)
1
.
0417
1+ S01
2
S 3
1+ 03
(1.0416)3
=
1 2 = 0.0792 (7.92%)
=
1
2
2
2
(1.0426)
1+ S02
2
1+
=
1+
4
1 2 = (1.0400) 1 2 = 0.0704 (7.04%)
3
(1.0416)3
S03
S04
2
If instead we wanted the expected spot yield curve one period from now under
the pure expectations theory, we can set t equal to 1 and vary j from 1 to 3 in the
preceding equation:
S12 = f12
S 2
1+ 02
2
=
1
1+ S01
2
S13 = f13
3
S03
1
+
2
=
1
1+ S01
2
(1.0426)2
2 = 0.0870 (8.70%)
1
2
1
(1.0417)1
2
1
3 2
(1.0416)
1 2 = 0.0831 (8.31%)
1 2 =
1
(1.0417)
S14 = f14
4
S04
1+
2
=
1
1+ S01
2
1 2 =
4
(1.0400)
1
(1.0417)
3
1 2 = 0.0789 (7.89%)
21-4
t = 2:
$1,080 YA + $0 YB = $1,120
1,120 28 308
=
=
1,080 27 297
28 3,240 2,240
120 80
27 1,000
27 27
27
1,000
10
YB =
=
=
=
=
29,700
27
29,700 29,700 297
1,100
27
So buying 308/297 of bond A and 10/297 of bond B gives the same cash flows as
buying 1 bond C (or, equivalently, buying 308 of bond A and 10 of bond B gives
the same cash flows as buying 297 of bond C). Therefore, if the Law of One Price
held, the bonds current prices would be related as follows:
308/297 PA + 10/297 PB = PC
But, since we are given that PA = $982, PB = $880 and PC = $1,010, we have instead:
308/297 $982 + 10/297 $880 = $1,048 > $1,010
The Law of One Price does not hold. For the Law of One Price to hold, bond C
would have to sell for $1,048.
21-5
T
d4 + $1,000 d 4 = $985
2
T
d2 + $1,000 d 2 = $900
2
T
$120 (1 T ) d 2 + $120 (1 T ) d4 + $40 d4 + $1,000 d4 = $1,040
2
$100 (1 T ) d 2 100
where
T = the ordinary income tax rate;
d2 =
d4 =
1
S02
1+
2
1
S04
1+
2
21-6
CFt t
t
i
t =1
1
+
2
D=
2 P0
T
10
50 t
1000 10
+
10
t
0.10 0.10
t =1
1
1
+
+
2
2
8.1
=
= 4.05 years.
D=
2 1000
2
t
t =1
D=
P0
T
(1+ i )
22-1
D=
1000
T
(1+ 0.10)
10
8
5
3
6.76
5.87
4.17
2.74
2.)
3.)
22-2
At t = 2:
At t = 3:
$0 YA + $1,100 YB + $0 YC = $550
Di
Rm R m + ei
Dm
If the yield curve is flat at 10%, then the first periods expected return is 10% for
each of the three bonds. Since the market portfolio is a weighted average of the
three bonds, the market portfolio also has an expected return of 10%. The
duration of the market portfolio is a weighted average of the three bonds
durations. Since the three bonds are assumed to be of equal value, the valueweighted market portfolio is also an equally weighted portfolio. Therefore, the
duration of the market portfolio is:
Dm = 1/3 5 + 1/3 10 +1/3 12 = 9 years
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 22
22-3
Therefore we have:
R A = 10%
5
(Rm 10% ) + e i
9
RB = 10%
10
(Rm 10% ) +e i
9
RC = 10%
12
(Rm 10% ) + e i
9
We have seen in an earlier chapter that, under the assumptions of the Sharpe
single-index model, the covariance between the returns on any pair of securities
i and j is:
2
ijj = i j m
Making the same assumptions as those for the Sharpe single-index model and
D
recognizing that i in the bond single-index model (equation (21.6)) is
Dm
analogous to i in the Sharpe single-index model, the covariance between the
returns on any pair of bonds i and j is:
ijj =
Di
Dm
Dj
Dm
2
m
Therefore we have:
AB =
AC =
BC =
DA
Dm
DA
Dm
DB
Dm
DB
5 10
2
2
m
=
m
Dm
9 9
DC
5 12
2
2
m
=
m
Dm
9 9
DC
10 12
2
2
m
=
m
Dm
9 9
22-4
23-1
The thicker line in the above diagram represents the profit from the combination. If
the options finish at the money, where the stock price at their expiration equals
their strike prices of $50, the profit would be $17 (a $17 loss). For the combination
to have a positive profit, the stock must either be below $41.50 or above $67 on
the day the options expire.
Algebraically, letting the stock price on the expiration date = P, the profit is:
P $50 :
Profit = $17 + 2 ($50 P) = $83 2P (since only the two put options would be
exercised)
$50 < P:
Profit = $17 + P $50 = P $67 (since only the call option would be exercised)
Elton, Gruber, Brown, and Goetzmann
Modern Portfolio Theory and Investment Analysis, 7th Edition
Solutions To Text Problems: Chapter 23
23-2
23-3
The thicker line in the above diagram represents the profit from the combination. If
the $40 call option finishes out of or at the money, where the stock price at its
expiration is below or equal to that options strike price of $40, the profit would be
$2, because none of the options would be exercised and therefore the profit is
simply the net profit from buying the $40 call option ( $8) and selling the two $45
call options ($10). If the two $45 call options finish at the money, where the stock
price on their expiration equals their strike price of $45, the profit would be $7,
equal to the net profit of $2 from buying and writing the options plus the $5 gain
from exercising the $40 call option. $7 is the maximum profit because, at stock
prices higher than $45, although exercising the $40 call option continues to
contribute a gain, the two $45 call options that were sold will be exercised against
the seller and therefore contribute twice the loss, so the profit declines, reaching
zero at a stock price of $52. (At a stock price of $52, the profit from the $40 call will
be $12 $8 = $4 and the profit from the two $45 calls will be $14 + $10 = $4,
giving a total profit of 0.) If the stock price is greater than $52 on the expiration
date, the profit will be negative (a loss).
Algebraically, letting the stock price on the expiration date = P, the profit is:
P $40 :
Profit = $2 (since no options would be exercised)
$40 < P < $45 :
Profit = $2 + P $40 (since only the $40 call option would be exercised)
$45 P :
Profit = $2 + P $40 2 (P $45) = $52 P (since all options would be exercised)
23-4
C = S0 B[a, n, P] Er n B[a, n, P]
where
P=
r d 1.1 0.9
=
= 0.67
u d 1.2 0.9
P =
1.2
u
P =
0.67 = 0.73
1.1
r
10
0.926 = $27.18
23-5
E
e rt
N(d2 )
We are given:
S0 = $95; E = $105; t = 2/3 years (8 months); = 0.60; r = 0.08 (8%)
Solving for d1 and d2 we have:
S
ln 0
E
d1 =
1
95
2
+ r + 2 t ln
+ 0.08 + 0.36
2
105
2
3 = 0.073 = 0.149
=
0.490
t
2
0.60
3
S
ln 0
E
d2 =
1
95
2
+ r 2 t ln
+ 0.08 0.36
2
105
2
3 = 0.167 = 0.341
=
0.490
t
2
0.60
3
$105
e
0.08
2
3
0.367 = $16.67
23-6
t=1
sell futures
$200
borrow $200/(1.06)
plus $4 at 6% for
six months
$188.68 + $4
= $192.68
$192.68(1.06)
= $204.24
$190
$4(1.06)=$4.24
________
$2.68
_______________
0
So the arbitrage profit is $2.68 per futures contract. If the present value (at t = 0) of
transactions costs is $2.68 or greater then the arbitrage opportunity is negated.
24-1
F
1+ R F 1
S
where RD is the domestic interest rate, RF is the foreign interest rate, F is the
domestic futures price for one unit of foreign currency, and S is the spot exchange
rate expressed as domestic currency per unit foreign currency; i.e., both F and S
are expressed in direct terms. From a U.S. viewpoint, the quotes given in the
problem are in indirect terms, so, if RD is the U.S. rate and RF is the rate for Japan,
then, from the problem, F = 1/115 and S = 1/120. So solving the above equation for
the U.S. rate gives:
1
R D = 115 (1.04 ) 1
1
120
120
=
(1.04 ) 1
115
= 0.0852 (8.52% )
24-2
24-3
14 3
= 1.833
6
See the table in the answers to Problem 5 for the remaining funds Sharpe ratios.
Chapter 25: Problem 2
The Treynor ratio is similar to the Sharpe ratio, except the funds beta is used in
the denominator instead of the standard deviation. E.g., for fund A we have:
R A RF
14 3
= 7.833
1.5
See the table in the answers to Problem 5 for the remaining funds Treynor ratios.
Chapter 25: Problem 3
A funds differential return, using standard deviation as the measure of risk, is the
funds average return minus the return on a nave portfolio, consisting of the
market portfolio and the riskless asset, with the same standard deviation of return
as the funds. E.g., for fund A we have:
R m RF
13 3
A = 14 3 +
6 = 1%
R A RF +
m
5
See the table in the answers to Problem 5 for the remaining funds differential
returns based on standard deviation.
25-1
R A RF + R m RF A = 14 (3 + (13 3 ) 1.5) = 4%
See the table in the answers to Problem 5 for the remaining funds Jensen alphas.
Chapter 25: Problem 5
This differential return measure is the same as the one used in Problem 4, except
that the riskless rate is replaced with the average return on a zero-beta asset.
E.g., for fund A we have:
The answers to Problems 1 through 5 for all five funds are as follows:
Fund
Sharpe
Ratio
Treynor
Ratio
A
B
C
D
E
1.833
2.250
1.625
1.063
1.700
7.333
18.000
13.000
14.000
8.500
Differential
Return
Based On
Standard
Deviation
1%
1%
3%
5%
3%
Differential
Return
Based On
Beta and RF
Differential
Return
Based On
Beta and R Z
4%
4%
3%
2%
3%
3.5%
3.5%
3.0%
1.5%
2.0%
25-2
RB 3
= 1.833
4
or
R B = 10.33%
So, for the ranking to be reversed, Fund Bs average return would have to be
lower than 10.33%.
25-3
Pi
Ri
0.05
0.05
0.75
0.04
0.05
0.65
0.01
.070
0.03
0.02
0.00
0.03
0.25
0.06
0.04
0.20
0.01
0.40
0.01
0.02
While there are only ten points on the Prediction Realization Diagram, certain
tendencies can be detected. It is very clear from the diagram that analysts in this
brokerage firm systematically overestimate earnings. Their forecasts have a strong
upward bias. The second marked tendency is fro the degree of overestimation to
grow as positive increases in earnings become larger. Similarly, there is a slight
(based on one observation) tendency for analysts to overestimate the size of a
decrease in earnings when a decrease takes place. The analysts misestimated the
direction of a change in earnings in only two out of the ten cases.
B.
Recall from the text that, for the computation of mean square forecast error
(MSFE), the results are the same whether we use predicted levels or predicted
changes in earnings. We will do the MSFE analysis using levels and the following
formula:
MSFE =
1
N
(F A )
i =1
where Fi is the forecasted level of earnings for firm i per share Ai is the actual
earnings per share for firm i.
26-1
Industry/Firm
A1
A2
A3
B4
B5
B6
B7
C8
C9
C10
(Fi Ai )2
Fi
Ai
$1.10
$1.37
$4.25
$2.10
$2.13
$3.25
$1.06
$2.70
$0.52
$1.16
$1.05
$1.35
$3.25
$2.12
$2.12
$2.80
$1.06
$2.40
$0.54
$1.20
0.0025
0.0004
1.0000
0.0004
0.0001
0.2025
0.0000
0.0900
0.0004
0.0016
Sum
1.2979
Therefore:
MSFE =
1.2979
= 0.1298
10
C.
From the text, we know that the MSFE can be decomposed by level of
aggregation as follows:
MSFE = P R
1
N
[(P
N
) (
P Ra R
)]
i =1
1
N
[(P P ) (R
N
Ra
)]
i =1
where the first term measures the forecast error due to all analysts misestimating
the average earnings in the economy, the second term measures the error due to
individual analysts misestimating the differential earnings for particular industries
from the average for the economy, and the third term measures the error due to
individual analysts misestimating the differential earnings for particular companies
within an industry from the average for that industry. So we have:
Error due forecasting sector of economy:
(P R)
26-2
1
N
=
[(P
N
) (
P Ra R
)]
i =1
1
2
= + 4 [(0.1825 0.223) (0.0725 0.048)]
10
+ 3 [(0.2167 0.223) (0.1367 0.048)]2
1
(0.0989 + 0.0169 + 0.0271) = 0.0143
10
[(P P ) (R
N
Ra
)]
= 0.0849
i =1
Notice that the sum of the three components equals 0.1298, which is the total
MSFE we calculated earlier.
To express each component as a percentage of the total MSFE, simply divide
each component by 0.1298 and multiply by 100:
Percent of forecast error due to forecasting sector of economy = 23.57%
Percent of forecast error due to forecasting each industry = 11.02%
Percent of forecast error due to forecasting each firm = 65.41%
D.
1. MSFE for each analyst:
MSFE(A) =
(P R )
i =1
1
1.0029 = 0.3343
3
MSFE(B) = 0.0508
MSFE(C) = 0.0307
26-3
Industry Error
= PA RA
Company Error
1
3
= 0.1272
[(P P ) (R
3
RA
)]
i =1
1 3
[(Pi 0.2833) (Ri ( 0.0733))]2
=
3 i =1
= 0.2071
% Industry Error
0.1272
100 = 38.05%
0.3343
% Company Error
0.2071
100 = 61.95%
0.3343
For analyst B,
Industry Error
Company Error
% Industry Error
= 23.8%
% Company Error
= 76.2%
1 4
[(Pi 0.1825) (Ri 0.0725)]2
4 i =1
= 0.0387
For analyst C,
Industry Error
Company Error
1 3
[(Pi 0.2167) (Ri 0.1367)]2
3 i =1
= 0.0243
=
% Industry Error
= 20.8%
% Company Error
= 79.2%
26-4
E.
The calculations in this part use N, not N 1, in the denominator for variances.
0.0306
100 = 23.57%
0.1298
0.0248
100 = 19.11%
0.1298
0.0744
100 = 57.32%
0.1298
26-5