CHAPTER6

OPTIMALRISKYPORTFOLIOS

1. (a)forsure.
(b)and(d)arefirmspecific.
(c)and(e)canbeeitherfirmspecificorduetomarketwidefactors.
2. (a)and(c)enterintotheportfoliovarianceandthusaffectportfoliorisk.
3. (a)istruebydefinition.
(b)isalsotrue:seeforinstancetheexampleinFigure6.15.
(c)isfalse,sinceitcannotbethetangencyportfolio.
(d)mayalsobefalse.

4.

Theparametersoftheopportunitysetare:
E(rS)=20%,E(rB)=12%,S=30%,B=15%,
Fromthestandarddeviationsandthecorrelationcoefficientwegeneratethecovariance
matrix[notethatCov(rS,rB)=SB]:
BondsStocks
Bonds22545
Stocks45900
Theminimumvarianceportfolioisfoundbyapplyingtheformula:
w

Min

(S)=
==.1739

Min

(B)=.8261

Themeanandstandarddeviationoftheminimumvarianceportfolioare:
E(r

Min

)=.173920+.82611213.39%
61

Min

=[W+W+2WSWBCov(S,B)]1/2

=[.17392900+.82612225+2.1739.826145]1/2=13.92%
5.
% in stocks
0.00%
17.39%
20.00%
40.00%
45.16%
60.00%
80.00%
100.00%

% in bonds
100.00%
82.61%
80.00%
60.00%
54.84%
40.00%
20.00%
0.00%

Exp. return
12.00
13.39
13.60
15.20
15.61
16.80
18.40
20.00

Std. Dev
15.00
13.92
13.94
15.70
16.54
19.53
24.48
30.00

minimum variance
tangency portfolio

6.

Thegraphapproximatesthepoints:
16.5
7.

E(r)

Min.VariancePortf. 13.4%
13.9%
TangencyPortfolio 15.6

The proportion of stocks in the optimal risky portfolio is given by:

WS=

[E(rS ) rf ] B2 [E(rB ) rf ]Cov(B,S)

[E(rS ) rf ] B2 [E(rB ) rf ]S2 [E(rS ) rf E(rB ) rf ]Cov(B,S)

==.4516
WB=.5484

Themeanandstandarddeviationoftheoptimalriskyportfolioare:
E(rp)=.451620+.548412=15.61%
p=[.45162900+.54842225+2.4516.548445]1/2=16.54%

62

8.

The reward-to-variability ratio of the optimal CAL is:

=

9. a.

15.61 8
=.4601
16.54

If you require your portfolio to yield a mean return of 14% you can find the corresponding standard
deviation from the optimal CAL. The formula for this CAL is:
E(rC)=rf+C=8+.4601C
SettingE(rC)equalto14%wefindthatthestandarddeviationoftheoptimal
portfoliois13.04%.

b.

TofindtheproportioninvestedinTbillswerememberthatthemeanofthecomplete
portfolio,14%,isanaverageoftheTbillrateandtheoptimalcombinationofstocksand
bonds,P.Letybetheproportioninthisportfolio.Themeanofanyportfolioalongthe
optimalCALis:
E(rC)=(ly)rf+yE(rp)=rf+y[E(rp)rf]=8+y(15.618)
SettingE(rC)=14%wefind:y=.7884,and1y=.2116,theproportioninTbills.
Tofindtheproportionsinvestedineachofthefundswemultiply.7884bythe
proportionsofthestocksandbondsintheoptimalriskyportfolio:
Proportionofstocksincompleteportfolio=.7884.4516=.3560
Proportionofbondsincompleteportfolio=.7884.5484=.4324

10.

Usingonlythestockandbondfundstoachieveaportfoliomeanof14%wemustfindthe
appropriateproportioninthestockfund,wS,andwB=1wSinthebondfund.The
portfoliomeanwillbe:
14=20wS+12(1wS)=12+8wSwS=.25
Sotheproportionswillbe25%instocksand75%inbonds.Thestandarddeviationof
thisportfoliowillbe:
p=(.252900+.752225+2.25.7545)1/2
=14.13%.
Thisisconsiderablylargerthanthestandarddeviationof13.04%achievedusingTbills
andtheoptimalportfolio.
63

11. a.
25.00

Optimal C AL

20.00
P

Stocks

15.00

10.00

Gold

5.00

0.00
0

10

20

30

40

Standard Deviation(%)

Eventhoughgoldseemsdominatedbystocks,itstillmightbeanattractiveassettohold
aspartofaportfolio.Ifthecorrelationbetweengoldandstocksissufficientlylow,itwill
beheldasanelementinaportfoliotheoptimaltangencyportfolio.
b.

Ifgoldhadacorrelationcoefficientwithstocksof+1,itwouldnotbeheld.Theoptimal
CALwouldbecomprisedofbillsandstocksonly.Sincethesetofrisk/return
combinationsofstocksandgoldwouldplotasastraightlinewithanegativeslope(see
thefollowinggraph),itwouldbedominatedbythestocksportfolio.Ofcourse,this
situationcouldnotpersist.Ifnoonedesiredgold,itspricewouldfallanditsexpected
rateofreturnwouldincreaseuntilitbecameanattractiveenoughassettohold.

64

25

20
Stocks

18
15

10

Gold

0
0.00

10.00

20.00

30.00

40.00

Standard Deviation(%)

12.

SinceAandBareperfectlynegativelycorrelated,ariskfreeportfoliocanbecreatedand
itsrateofreturninequilibriumwillbetheriskfreerate.Tofindtheproportionsofthis
portfolio(withwAinvestedinAandwB=1wAinB),setthestandarddeviationequal
tozero.Withperfectnegativecorrelation,theportfoliostandarddeviationreducesto
P=Abs[wAAwBB]
0=5wA10(1wA)
wA=.6667
Theexpectedrateofreturnonthisriskfreeportfoliois:
E(r)=.666710+.333315=11.67%
Therefore,theriskfreeratemustalsobe11.67%.

13.

False. If the borrowing and lending rates are not identical, then depending on the tastes of the individuals
(that is, the shape of their indifference curves), borrowers and lenders could have different optimal risky
portfolios.

14.

False.Theportfoliostandarddeviationequalstheweightedaverageofthecomponent
assetstandarddeviationsonlyinthespecialcasethatallassetsareperfectlypositively
65

correlated.Otherwise,astheformulaforportfoliostandarddeviationshows,theportfolio
standarddeviationislessthantheweightedaverageofthecomponentassetstandard
deviations.Theportfoliovariancewillbeaweightedsumoftheelementsinthe
covariancematrix,withtheproductsoftheportfolioproportionsasweights.

15.

Theprobabilitydistributionis:
Probability RateofReturn
.7
100%
.3
50%
Mean=.7100+.3(50)=55%
Variance=.7(10055)2+.3(5055)2=4725
Standarddeviation=47251/2=68.74%

16.

P=30=yy
y=.75
E(r )=12+.75(3012)=25.5%
p

17.a. Restrictingtheportfolioto20stocksratherthan4050willincreasetheriskofthe
portfolio,butpossiblynotbymuch.If,forinstance,the50stockshadthesamestandard
deviation,,andthecorrelationsbetweeneachpairwereidenticalwithacorrelation
coefficientof(sothatthecovariancebetweeneachpairwouldbe2),thevarianceof
anequallyweightedportfoliowouldbe(seeAppendixA,equation8A.4),
=2+2
Theeffectofthereductioninnonthesecondtermwouldberelativelysmall(since49/50
iscloseto19/20and2issmallerthan2,butthedenominatorofthefirsttermwould
be20insteadof50.Forexample,if=45%and=.2,thenthestandarddeviationwith
50stockswouldbe20.91%,andwouldriseto22.05%whenonly20stocksareheld.
Suchanincreasemightbeacceptableiftheexpectedreturnissufficientlyincreased.
b.

Hennessycouldcontaintheincreaseinriskbymakingsurethathemaintainsreasonable
diversificationamongthe20stocksthatremaininhisportfolio.Thisentailsmaintaining
alowcorrelationamongtheremainingstocks.Forexample,inpart(a),with=.2,the
increaseinportfolioriskwasminimal.Asapracticalmatter,thismeansthatHennessy
wouldneedtospreadhisportfolioamongmanyindustries;concentratingonjustafew
wouldresultinhighercorrelationamongtheincludedstocks.
66

18.

Riskreductionbenefitsfromdiversificationarenotalinearfunctionofthenumberof
issuesintheportfolio.Rather,theincrementalbenefitsfromadditionaldiversification
aremostimportantwhenyouareleastdiversified.RestrictingHenneseyto10insteadof
20issueswouldincreasetheriskofhisportfoliobyagreateramountthanwould
reducingthesizeoftheportfoliofrom30to20stocks.Inourexample,restrictingthe
numberofstocksto10willincreasethestandarddeviationto23.81%.Theincreasein
standarddeviationof1.76%fromgivingup10of20stocksisgreaterthantheincreaseof
1.14%fromgivingup30stockswhenstartingwith50.

19.

The point should be well taken because the committee should be concerned with the volatility of the
entire portfolio. Since Hennessey's portfolio is only one of six well-diversified portfolios, and smaller
than the average, the concentration in fewer issues could have a minimal effect on the diversification of
the total fund. Hence, unleashing Hennessey to do stock picking may be advantageous.

20.

Intuitively, we note that since all stocks have the same expected rate of return and standard deviation, we
wish to choose the stock that will result in lowest risk. This will be the one with the lowest correlation
with stock A.
Moreformally,wenotethatwhenallstockshavethesameexpectedrateofreturn,the
optimalportfolioforanyriskaverseinvestoristheglobalminimumvarianceportfolio
(G).WhenrestrictedtoAandonemorestock,theobjectiveistofindGforanypairthat
includesA,andselectthecombinationwiththelowestvariance.Withtwostocks,Iand
J,theformulafortheweightsinGis:

wMin(I)=
wMin(J)=1wMin(I)
Sinceallstandarddeviationsareequalto20%,
Cov(I,J)=IJ=400,and
wMin(I)=wMin(J)=.5
Thisintuitiveresultisanimplicationofapropertyofanyefficientfrontier,namely,that
67

thecovarianceoftheglobalminimumvarianceportfoliowithanyotherassetonthe
frontierisidenticalandequaltoitsownvariance.(Otherwise,additionaldiversification
wouldfurtherreducethevariance.)Inthiscase,thestandarddeviationofG(I,J)will
reduceto:
MinG)=[200(1+(I,J)]1/2
Thisleadsusdirectlytotheintuitiveresultthatthedesiredadditionwouldbethestock
withthelowestcorrelationwithA,whichisD.Theoptimalportfolioisequallyinvested
inAandD,andthestandarddeviationwillbe17.03%.

21.

No,atleastaslongastheyarenotrisklovers.Riskneutralinvestorswillnotcarewhich
portfoliotheyholdsinceallportfoliosyield8%.

22.

No change. The efficient frontier of risky assets is horizontal at 8%, so the optimal CAL runs from the
risk-free rate through G. The best G here, again, is the one with the lowest variance. The optimal
complete portfolio will, as usual, depend on risk aversion.

23.

d.PortfolioYcannotbeefficientbecauseitisdominatedbyanotherportfolio.For
example,PortfolioXhashigherexpectedreturnandlowerstandarddeviation.

24.

(c)

25.

(d)

26.

(b)

27.

(a)

28.

(c)

29.

Sincewedonothaveanyinformationaboutexpectedreturns,wefocusexclusivelyon
68

reducingvariability.StocksAandChaveequalstandarddeviations,butthecorrelation
ofStockBwithStockC(0.10)islessthanthatofStockAwithStockB(0.90).
Therefore,aportfoliocomprisedofStocksBandCwillhavelowertotalriskthana
portfoliocomprisedofStocksAandB.
30.

Rearrangingthetable(convertingrowstocolumns),andcomputingserialcorrelation
resultsinthefollowingtable:
NominalRates
Small
company
1920s*
1930s
1940s
1950s
1960s
1970s
1980s
1990s
Serial Correlation

-3.72
7.28
20.63
19.01
13.72
8.75
12.46
13.84
0.46

Large
company

L.T. Govt
Bonds

18.36
-1.25
9.11
19.41
7.84
5.90
17.60
18.20
-0.22

3.98
4.60
3.59
0.25
1.14
6.63
11.50
8.60
0.60

Intermediate
Govt Bonds
3.77
3.91
1.70
1.11
3.41
6.11
12.01
7.74
0.59

T-Bills

Inflation

3.56
0.30
0.37
1.87
3.89
6.29
9.00
5.02
0.63

Forexample:tocomputeserialcorrelationindecadenominalreturnsforlargecompany
stocks,wesetupthefollowingtwocolumnsandusetheCorrelationfunctionofthe
spreadsheettofindthattheserialcorrelationis0.22.

1930s
1940s
1950s
1960s
1970s
1980s
1990s

Decade

Previous

-1.25%

18.36%

9.11%

-1.25%

19.41%

9.11%

7.84%

19.41%

5.90%

7.84%

17.60%

5.90%

18.20%

17.60%

Notethateachcorrelationisbasedononlysevenobservations,sowecannotreallyarrive
atanystatisticallysignificantconclusion.Lookingatthenumbers,however,itappears
thatthereispersistentserialcorrelationwiththeexceptionoflargecompanystocks.This
conclusionchangeswhenweturntorealratesinthenextproblem.

69

-1.00
-2.04
5.36
2.22
2.52
7.36
5.10
2.93
0.23

31.

Thetableforrealrates(usingtheapproximationofsubtractingadecadesaverage
inflationfromthedecadesaveragenominalreturn)is:
Small
company
1920s*
1930s
1940s
1950s
1960s
1970s
1980s
1990s
Serial Correlation

-2.72
9.32
15.27
16.79
11.20
1.39
7.36
10.91
0.29

Large
company
19.36
0.79
3.75
17.19
5.33
-1.46
12.50
15.27
-0.27

L.T. Govt
Bonds
4.98
6.64
-1.77
-1.97
-1.38
-0.73
6.40
5.67
0.38

Intermediate
Govt Bonds

T-Bills

4.77
5.95
-3.66
-1.11
0.89
-1.25
6.91
4.81
0.11

4.56
2.34
-4.99
-0.35
1.37
-1.07
3.90
2.09
0.00

Thepositiveserialcorrelationindecadenominalreturnshasvanishedanditappearsthatreal
ratesareseriallyuncorrelated.Thedecadetimeseries(althoughagaintooshortforany
definitiveconclusion)suggeststhatrealratesofreturnareindependentfromdecadetodecade.
32. FundDrepresentsthesinglebestadditiontocomplementStephenson'scurrentportfolio,given
hisselectioncriteria.First,FundDsexpectedreturn(14.0percent)hasthepotentialtoincrease
theportfoliosreturnsomewhat.Second,FundDsrelativelylowcorrelationwithhiscurrent
portfolio(+0.65)indicatesthatFundDwillprovidegreaterdiversificationbenefitsthananyof
theotheralternativesexceptFundB.TheresultofaddingFundDshouldbeaportfoliowith
approximatelythesameexpectedreturnandsomewhatlowervolatilitycomparedtotheoriginal
portfolio.
Theotherthreefundshaveshortcomingsintermsofeitherexpectedreturnenhancementor
volatilityreductionthroughdiversificationbenefits.FundAoffersthepotentialforincreasing
theportfoliosreturn,butistoohighlycorrelatedtoprovidesubstantialvolatilityreduction
benefitsthroughdiversification.FundBprovidessubstantialvolatilityreductionthrough
diversificationbenefits,butisexpectedtogenerateareturnwellbelowthecurrentportfolios
return.FundChasthegreatestpotentialtoincreasetheportfoliosreturn,butistoohighly
correlatedtoprovidesubstantialvolatilityreductionbenefitsthroughdiversification.
33.

a.SubscriptOPreferstotheoriginalportfolio,ABCtothenewstock,andNPtothenew
portfolio.
i.

E(rNP)=wOPE(rOP)+wABCE(rABC)=(0.90.67)+(0.11.25)=0.728%
610

ii.
iii.

b.

Cov=rOPABC=0.402.372.95=2.79662.80
NP=[w2OP2OP+w2ABC2ABC+2wOPwABC(CovOP,ABC)]1/2
=[(0.922.372)+(0.122.952)+(20.90.12.80)]1/2
=2.2673%2.27%
SubscriptOPreferstotheoriginalportfolio,GStogovernmentsecurities,andNPto
thenewportfolio.

i.
ii.
iii.

E(rNP)=wOPE(rOP)+wGSE(rGS)=(0.90.67)+(0.10.042)=0.645%
Cov=rOPGS=02.370=0
NP=[w2OP2OP+w2GS2GS+2wOPwGS(CovOP,GS)]1/2
=[(0.922.372)+(0.120)+(20.90.10)]1/2
=2.133%2.13%
c. Adding the risk-free government securities would result in a lower beta for the new
portfolio. The new portfolio beta will be a weighted average of the individual security
betas in the portfolio; the presence of the risk-free securities would lower that weighted
average.
d.

The comment is not correct. Although the respective standard deviations and expected
returns for the two securities under consideration are equal, the covariances between
each security and the original portfolio are unknown, making it impossible to draw the
conclusion stated. For instance, if the covariances are different, selecting one security
over the other may result in a lower standard deviation for the portfolio as a whole. In
such a case, that security would be the preferred investment, assuming all other factors
are equal.
e.i.Graceclearlyexpressedthesentimentthattheriskoflosswasmoreimportanttoher
thantheopportunityforreturn.Usingvariance(orstandarddeviation)asameasure
ofriskinhercasehasaseriouslimitationbecausestandarddeviationdoesnot
distinguishbetweenpositiveandnegativepricemovements.
ii.Twoalternativeriskmeasuresthatcouldbeusedinsteadofvarianceare:
RangeofReturns,whichconsidersthehighestandlowestexpectedreturnsinthe
futureperiod,withalargerrangebeingasignofgreatervariabilityandthereforeof
greaterrisk.
Semivariancewhichcanmeasureexpecteddeviationsofreturnsbelowthemean,or
someotherbenchmark,suchaszero.
EitherofthesemeasureswouldpotentiallybesuperiortovarianceforGrace.Range
ofreturnswouldhelptohighlightthefullspectrumofrisksheisassuming,
especiallythedownsideportionoftherangeaboutwhichsheissoconcerned.
Semivariancewouldalsobeeffective,becauseitimplicitly assumes that the
611

investor wants to minimize the likelihood of returns falling below some target rate; in
Graces case, the target rate would be set at zero (to protect against negative
returns).
34.

a. Systematicriskreferstofluctuationsinassetpricescausedbymacroeconomicfactors
thatarecommontoallriskyassets;hencesystematicriskisoftenreferredtoasmarket
risk.Examplesofsystematicriskfactorsincludethebusinesscycles,inflation,
monetarypoliciesandtechnologicalchanges.
Firmspecificriskreferstofluctuationsinassetpricescausedbyfactorsthatare
independentofthemarketsuchasindustrycharacteristicsorfirmcharacteristics.
Examplesoffirmspecificriskfactorsincludelitigation,patents,management,and
financialleverage.
b. Trudyshouldexplaintotheclientthatpickingonlythetopfivebestideaswouldmost
likelyresultintheclientholdingamuchmoreriskyportfolio.Thetotalriskofa
portfolio,orportfoliovariance,isthecombinationofsystematicriskandfirmspecific
risk.
Thesystematiccomponentdependsonthesensitivityoftheindividualassetstothe
marketmovementsasmeasuredbybeta.Assumingtheportfolioiswelldiversified,
thenumberofassetswillnotaffectthesystematicriskcomponentofportfolio
variance.Theportfoliobetadependsontheindividualsecuritybetasandtheportfolio
weightsofthosesecurities.
Ontheotherhand,thecomponentsoffirmspecificrisk(sometimescalled
nonsystematicrisk)arenotperfectlypositivelycorrelatedwitheachotherand,asmore
assetsareaddedtotheportfolio,thoseadditionalassetstendtoreduceportfoliorisk.
Hence,increasingthenumberofsecuritiesinaportfolioreducesfirmspecificrisk.
Forexample,apatentexpirationforonecompanywouldnotaffecttheothersecurities
intheportfolio.Anincreaseinoilpricesmighthurtanairlinestockbutaidanenergy
stock.Asthenumberofrandomlyselectedsecuritiesincreases,thetotalrisk
(variance)oftheportfolioapproachesitssystematicvariance.

612