ECON F412/FIN F313: SECURITY ANALYSIS AND PORTFOLIO MANAGEMENT

First Semester, 2021-22

Problem Set – I [Portfolio Theory]: Solutions

1. Expected return, E(r) = (0.7*0.12) + (0.3*0.06) = (0.084 + 0.018) = 0.102, i.e., 10.2%
Risk = 0.7*0.15 = 0.105, i.e., 10.5%.

2. The portfolio with the highest diversification benefit will have the lowest correlation
among its stocks. For a portfolio consisting of assets 1 and 2, portfolio correlation is
given by ρ12 = σ12/σ1σ2
ρAB = σAB/σAσB = 0.015/(0.18*0.16) = 0.52
ρBC = σBC/σBσC = 0.03/(0.16*0.25) = 0.75
ρCA = σCA/σCσA = 0.021/(0.25*0.18) = 0.47
The portfolio consisting of stocks A and C would be the best option among these for
diversification.

3. σp2 = wD2σD2 + wE2σE2 + 2wDwEσDE

In the minimum variance portfolio, we minimize σp2 subject to the constraint wD + wE
= 1, and on doing so, obtain
wD,min = (σE2 – σDE)/(σE2 + σD2 - 2σDE)
wD,min = ((0.35*0.35) – 0.055)/((0.35*0.35) + (0.18*0.18) – 2*0.055) = 0.0675/0.0449
wD,min = 1.5033 and wE,min = 1 – 1.5033 = -0.5033
Hence, investing in the minimum variance portfolio involves short-selling equity, and
increasing investment in debt.
E(r) = (1.5033*0.15) + (-0.5033*0.25) = 0.09967, i.e., 9.97%
Risk = ((1.5033*1.5033*0.18*0.18) + (-0.5033*-0.5033*0.35*0.35) + 2*1.5033*-
0.5033*0.055)1/2 = 0.021021/2 = 0.145, i.e., 14.5%.

4. E(r) = wA*0.24 + wB*0.16 = 0.21

Considering wA + wB = 1,
wA*0.24 + (1 – wA)*0.16 = 0.21
wA*0.08 + 0.16 = 0.21
wA = (0.21 – 0.16)/0.08 = 0.05/0.08 = 0.625
wB = 1 – wA = 0.375
Portfolio risk is given by σ = (wA2σA2 + wB2σB2 + 2wAwBρABσAσB)1/2
From this,
ρAB = (σ2 – wA2σA2 – wB2σB2)/(2wAwBσAσB)
= ((0.27*0.27) – (0.625*0.625*0.32*0.32) – (0.375*0.375*0.2*0.2)) /
(2*0.625*0.375*0.32*0.2)
= 0.027275/0.03
= 0.91
Since the correlation between the stocks is very high, this is not a well-diversified
portfolio to invest in.

5. a. The index of risk aversion is given by

A = (E(rp) - rf)/(y*σp2), where rp and σp refer to the return and risk of the risky
portfolio.
A = (0.21 – 0.08)/(0.65*(0.27*0.27)) = 0.13/0.047385 = 2.744

b. E(r) = (0.65*0.21) + (0.35*0.08) = 0.1365 + 0.028 = 0.1645, i.e., 16.45%

Risk = 0.65*0.27 = 0.1755, i.e., 17.55%.