Chapter 6 - Capital Allocation to Risky Assets

CHAPTER 6: CAPITAL ALLOCATION TO RISKY ASSETS

PROBLEM SETS

4. a. The expected cash flow is: (0.5 × $70,000) + (0.5 × 200,000) = $135,000.
With a risk premium of 8% over the risk-free rate of 6%, the required rate of
return is 14%. Therefore, the present value of the portfolio is:
$135,000/1.14 = $118,421

b. If the portfolio is purchased for $118,421 and provides an expected cash

inflow of $135,000, then the expected rate of return [E(r)] is as follows:
$118,421 × [1 + E(r)] = $135,000
Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate
of return with the required rate of return.

c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407

d. For a given expected cash flow, portfolios that command greater risk
premiums must sell at lower prices. The extra discount from expected
value is a penalty for risk.

5. When we specify utility by U = E(r) – 0.5Aσ,2 the utility level for T-bills is: 0.07
The utility level for the risky portfolio is:
U = 0.12 – 0.5 × A × (0.18)2 = 0.12 – 0.0162 × A
In order for the risky portfolio to be preferred to bills, the following must hold:
0.12 – 0.0162A > 0.07  A < 0.05/0.0162 = 3.09
A must be less than 3.09 for the risky portfolio to be preferred to bills.

13. Expected return = (0.7 × 18%) + (0.3 × 8%) = 15%

Standard deviation = 0.7 × 28% = 19.6%

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Chapter 6 - Capital Allocation to Risky Assets

14. Investment proportions: 30.0% in T-bills

0.7 × 25% = 17.5% in Stock A
0.7 × 32% = 22.4% in Stock B
0.7 × 43% = 30.1% in Stock C

.18  .08
15. Your reward-to-volatility ratio: S   0.3571
.28
.15  .08
Client's reward-to-volatility ratio: S   0.3571
.196

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Chapter 6 - Capital Allocation to Risky Assets

16.

30
CAL (Slope = 0.3571)
25

20

E(r)% P
15
Client
10

0
0 10 20 30 40



17. a. E(rC) = rf + y × [E(rP) – rf] = 8 + y × (18  8)

If the expected return for the portfolio is 16%, then:
.16  .08
16% = 8% + 10% × y  y   0.8
.10
Therefore, in order to have a portfolio with expected rate of return equal to
16%, the client must invest 80% of total funds in the risky portfolio and 20%
in T-bills.

b.
Client’s investment proportions: 20.0% in T-bills
0.8 × 25% = 20.0% in Stock A
0.8 × 32% = 25.6% in Stock B
0.8 × 43% = 34.4% in Stock C

c. σC = 0.8 × σP = 0.8 × 28% = 22.4%

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Chapter 6 - Capital Allocation to Risky Assets

18. a. σC = y × 28%
If your client prefers a standard deviation of at most 18%, then:
y = 18/28 = 0.6429 = 64.29% invested in the risky portfolio.

b. E (rC )  .08  .1  y  .08  (0.6429  .1)  14.429%

E(rP )  r f 0.18  0.08 0.10

19. a. y*     0.3644
Aσ 2
P 3.5  0.28 2
0.2744
Therefore, the client’s optimal proportions are: 36.44% invested in the risky
portfolio and 63.56% invested in T-bills.

b. E(rC) = 0.08 + 0.10 × y* = 0.08 + (0.3644 × 0.1) = 0.1164 or 11.644%

C = 0.3644 × 28 = 10.203%

.08  .05
21. a. E(rC) = 8% = 5% + y × (11% – 5%)  y   0.5
.11  .05

b. σC = y × σP = 0.50 × 15% = 7.5%

c. The first client is more risk averse, preferring investments that have less risk
as evidenced by the lower standard deviation.

22. Johnson requests the portfolio standard deviation to equal one half the market
portfolio standard deviation. The market portfolio  M  20% , which implies
 P  10% . The intercept of the CML equals rf  0.05 and the slope of the CML
equals the Sharpe ratio for the market portfolio (35%). Therefore using the CML:
E ( rM )  rf
E (rP )  rf   P  0.05  0.35  0.10  0.085  8.5%
M
23. Data: rf = 5%, E(rM) = 13%, σM = 25%, and rfB = 9%
The CML and indifference curves are as follows:

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Chapter 6 - Capital Allocation to Risky Assets

24. For y to be less than 1.0 (that the investor is a lender), risk aversion (A) must be
large enough such that:
E(rM )  r f 0.13  0.05
y 1  A   1.28
Aσ 2
M
0.25 2
For y to be greater than 1 (the investor is a borrower), A must be small enough:
E (rM )  r f 0.13  0.09
y 1  A   0.64
Aσ 2
M
0.25 2
For values of risk aversion within this range, the client will neither borrow nor
lend but will hold a portfolio composed only of the optimal risky portfolio:
y = 1 for 0.64 ≤ A ≤ 1.28

25. a. The graph for Problem 23 has to be redrawn here, with:

E(rP) = 11% and σP = 15%

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Chapter 6 - Capital Allocation to Risky Assets

0.11  0.05
b. For a lending position: A   2.67
0.15 2
0.11  0.09
For a borrowing position: A   0.89
0.15 2
Therefore, y = 1 for 0.89 ≤ A ≤ 2.67

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