Solutions to Qs 6, 7, 8, 10, 14 and 15 of Chapter 8 of textbook

Q. 6: In terms of the Markowitz model, how an investor might go about identifying his
or her optimal portfolio, would be as follows: -

(i) Identify the efficient set of portfolios from a feasible set of portfolios
created from available securities. The efficient set would comprise all
those portfolios that have the highest expected returns for each level of
risk and the lowest risk for each level of return. In the following chart,
portfolios lying along the line above the point A comprise the efficient set.

(ii) Create a set of indifference curves specific to the investor.

(iii) Superimpose the set of indifference curves atop the efficient set of
portfolios and identify the tangential point at which an indifference curve
meets the curve representing the efficient set. Optimal portfolio is
represented at point T on the chart on the next page.

(iv) Information required for an investor to identify the Optimal Portfolio is:

(a) Information required to identify the Efficient Set from available

securities: (1) expected return of each available security; (2) variance
of each available security; (3) covariance of each pair included in the
set of available securities.
(b) Information required to create a set of Indifference Curves for the
investor; namely each combination of expected return and standard
 deviation that provides equal utility (or satisfaction) for each
Indifference Curve.

Q 7: The correlation coefficient between the 2 securities that comprise Dode Brinker’s
portfolio, that will produce the maximum standard deviation of the specified 2-
security portfolio will be +1 and correlation coefficient between the same 2
securities of –1 will produce the minimum standard deviation of the same
portfolio.

The general formula (in terems of correlations) to determine a portfolio’s standard

deviation for a 2-security portfolio is:

σp = [X2A σ2A + X2B σ2B + 2 σA σB ρAB] 1/2

Applying values provided in the question to the above formula:

(i) For maximum standard deviation (ρAB = +1):

σp = [.352 * 20%2 + .652 * 25%2 + 2*.35*65*20%*25%*(+1)] 1/2

= [.0049 + .0264 + .02275] 1/2 = 23.25%

(ii) For minimum standard deviation (ρAB = -1):

σp = [.352 * 20%2 + .652 * 25%2 + 2*.35*65*20%*25%*(+1) ] 1/2

= [.0049 + .0264 - .02275] 1/2 = 9.25%

Q 8: Expected return of Leslie Nunamaker’s portfolio, assuming expected return on the

market index of 12%, is:

rp = 1.5% + 0.90*12% + 0 = 1.5% + 10.8% = 12.3%

Q 14: In the Market Model, the standard deviation of a portfolio is provided by the
following general formula: -

σp = [β2pI σ2I + σ2εp]1/2

Where:

β2pI = [Σ Xi βiI]2
σ2εp = Σ X2i σ2iI

Applying values provided in the Question to the above formulae:

σ2εp = 0.302 * 5%2 + 0.502 * 8%2 + 0.202 * 2%2

= 0.000225 + 0.0016 + 0.000016 = 0.001841

β2pI = [0.30 * 1.20 + 0.50 * 1.05 + 0.20 * 0.90]2

= [0.36 + 0.525 + 0.18]2 = 1.134

σp = [1.134225 * 18%2 + 0.001841]1/2

= [0.0367488 + 0.001841]1/2 = 19.64%

Q 15: Using the same formulae as are used in the preceding question, the calculations
based on information provided are as follows:

(i) For the 4-securities portfolio:

σ2εp = 4 * 0.252 * 30%2 = 0.0225

β2pI = [4 * 0.25 * 1.00]2 = 1.00

σp = [1.00 * 20%2 + 0.0225]1/2 = [0.04 + 0.0225]1/2 = 25%

(ii) For the 10-securities portfolio:

σ2εp = 10 * 0.12 * 30%2 = 0.009

β2pI = [10 * 0.1 * 1.00]2 = 1.00

σp = [1.00 * 20%2 + 0.009]1/2 = [0.04 + 0.009]1/2 = 22.14%