Investments Problem Set

GT 4.11) Assume in exercise 4.9 that ABCO decides to borrow $8 billion at 5 percent interest to
triple its current investment in each of its four lines of businesses. Assume this new investment
has the same per dollar return outcomes as the old investment.

a. Answer parts a and b of exercise 4.9 given the new investment.

Scenarios
Investment Poor Average Good Same probability Good 2x others
ENT $1,200 20% -5% -8% 2.33% -0.25%
CON $800 15% 10% -20% 1.67% -3.75%
PHA $1,400 -10% -5% 27% 4.00% 9.75%
INS $600 -10% 10% 10% 3.33% 5.00%

Assuming that returns remain constant, the expected returns do not change with the $8B
investment.

Scenarios
Investment Weight Poor Average Good Same probability Good 2x others
ENT $3,600 90% 20% -5% -8% 2.33% -0.25%
CON $2,400 60% 15% 10% -20% 1.67% -3.75%
PHA $4,200 105% -10% -5% 27% 4.00% 9.75%
INS $1,800 45% -10% 10% 10% 3.33% 5.00%
Debt -$8,000 -200% 5% 5% 5% 5.00% 5.00%
$4,000 -1.20% 0.01%
b. How does this result compare with the results from exercise 4.9? Why?
Scenarios
Investment Weight Poor Average Good Same probability Good 2x others Variance STDDEVp1 STDDEVp2
ENT $3,600 90% 20% -5% -8% 2.33% -0.25% 0.11% 12.55% 12.82%
CON $2,400 60% 15% 10% -20% 1.67% -3.75% 0.05% 15.46% 16.38%
PHA $4,200 105% -10% -5% 27% 4.00% 9.75% 0.28% 16.39% 17.37%
INS $1,800 45% -10% 10% 10% 3.33% 5.00% 0.09% 9.43% 9.57%
Debt -$8,000 -200% 5% 5% 5% 5.00% 5.00% -0.77% 0.00% 0.00%
$4,000 2.0% -9.3% 3.7% -1.20% 0.013%

Covariance ENT CON PHA INS Debt

ENT 1.58% 1.33% -1.40% -1.18% 0.00%
CON 2.39% -2.53% -0.89% 0.00%
PHA 2.69% 0.93% 0.00%
INS 0.89% 0.00%
Debt 0.00%

Varp1 0.33%
Varp2 0.29%

Expected return is lower due to the 5% cost of debt

c. To whom does this return belong? Why?

As it is assumed that debt is paid as part of the portfolio, the returns belong to the equity
investors in ABCO.

GT 4.19

Asset Weight
Nike 71.4%
Cisco -14.3%
GE 42.9%

GT 5.2

Compute the tangency portfolio weights assuming a risk-free asset yields 5 percent:

Asset Weight
AOL 70%
MSFT -7%
INTC 37%

GT 5.4

16%
AOL
14%

12% MSFT
Mean Return

10% INTC

8%

6%

4%

2%

0%
0.00% 1.00% 2.00% 3.00% 4.00% 5.00%
Variance

GT 4.23

Variance of 3.81%
GT 5.2

AOL 50%

INTC 50%

Computer Exercise

Foreign

Questions

a) The US has a higher correlation to the rest of the assets than Canada. That is why in the
MVP portfolio there is a lower weight for the US. In the tangency portfolio, Canada has a
lower expected return and as such its weight is reduced – the tangency portfolio seeks to
maximize expected returns.
b) France has a low correlation to other assets, hence including it in the MVP portfolio helps
reduce risk.

Industries
Covariance Matrix
Food&Bev. Chemical Oil Manuf. Utilities Retail Financial
Food&Bev. 0.00207513 0.00177951 0.00107838 0.001829942 0.001203157 0.001996274 0.001671313
Chemical 0.00177951 0.00218419 0.00127136 0.002105087 0.001073143 0.002050951 0.001695817
Oil 0.001078378 0.00127136 0.00257772 0.001127848 0.001108776 0.001297223 0.00133272
Manuf. 0.001829942 0.00210509 0.00112785 0.002968276 0.001012914 0.002450228 0.001776703
Utilities 0.001203157 0.00107314 0.00110878 0.001012914 0.001518441 0.001215361 0.001274178
Retail 0.001996274 0.00205095 0.00129722 0.002450228 0.001215361 0.003051619 0.00207412
Financial 0.001671313 0.00169582 0.00133272 0.001776703 0.001274178 0.00207412 0.002192931

Inverted Covariance Matrix

Food&Bev. Chemical Oil Manuf. Utilities Retail Financial MVP Tang.
Food&Bev. 2274.183897 -1021.7911 188.80566 -11.64758729 -638.604797 -440.0852063 -261.087238 1 0.009891
Chemical -1021.791146 2526.45317 -308.54908 -865.7623762 130.9757887 -26.0121646 -337.535454 1 0.010069
Oil 188.8056599 -308.54908 656.426751 72.2420633 -301.603425 -15.73758169 -172.626382 1 0.008336
Manuf. -11.64758729 -865.76238 72.2420633 1383.807102 112.8211668 -621.3502024 35.45458283 1 0.011922
Utilities -638.6047975 130.975789 -301.60342 112.8211668 1591.927977 105.2965777 -547.257363 1 0.005112
Retail -440.0852063 -26.012165 -15.737582 -621.3502024 105.2965777 1534.39496 -643.944241 1 0.013852
Financial -261.0872376 -337.53545 -172.62638 35.45458283 -547.257363 -643.944241 1919.234078 1 0.01031
MVP weights Tangent weights
Food&Bev. 89.77358279 11.96% 1.58785877 32.59%
Chemical 97.77874056 13.03% -0.731232819 -15.01%
Oil 118.9580038 15.85% 1.553990493 31.89%
Manuf. 105.5647494 14.07% 0.602082852 12.36%
Utilities 453.5559248 60.44% -2.212914543 -45.41%
Retail -107.4378579 -14.32% 2.999626024 61.56%
Financial -7.762017383 -1.03% 1.07343667 22.03%
750.4311261 1 4.872847447 1

Expected return 0.0119134 Expected return 0.019740124

Variance 0.00133257 Variance 0.002938759
Stdev. 0.03650435 Stdev. 0.054210322
Sharpe ratio 0.17788011 Sharpe ratio 0.264158629

Recommendation

Depending on risk aversion, I would suggest to invest in the tangent portfolio so it maximizes
expected return and sharpe ratio and, depending on the investor risk profile, the tradeoff of
volatility (variance) is not that much.
Questions

Why are the portfolio weights so different under the minimum variance and Tangent
portfolios?

Because both portfolios have a different objective, the tangent portfolio tries to maximize
expected return whereas the MVP portfolio tries to minimize volatility (variance). According to
portfolio theory there is a positive correlation between risk (variance) and expected return so
the portfolios are almost inverse one from each other.