Alex Nicholson

Investment HW 3

Question 1.

You manage a risky portfolio with an expected rate of return of 18% and a standard deviation of
28%. The T-bill rate is 8%.

Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete portfolio’s
standard deviation will not exceed 18%.

a. What is the investment proportion, y?

Y=.18/.28 =0.6429 = 64.29%

b. What is the expected rate of return on the complete portfolio?

E(rc)= .08+.6429(.18-0.8)
E(rc)= .1443= 14.43%
14.43% expected rate of return for the entire portfolio

Question 2.

You manage a risky portfolio with an expected rate of return of 18% and a standard deviation of
28%. The T-bill rate is 8%. Your client chooses to invest 70% of a portfolio in your fund and
30% in a T-bill money market fund.
What is the reward-to-volatility (Sharpe) ratio (S) of your risky portfolio? Your client’s?

Sharpe Ratio of my risky portfolio = (0.18-0.08)/0.28 = .3571 = 35.71%

Client Portfolio Return =.7(.18) +.3(0.08) = 0.126+0.024 = 0.15

Client Portfolio STD = 0.7*0.28 = 0.196

Sharpe Ratio of the Client Portfolio = (0.15-0.08)/0.196 = 0.3571 = 35.71

Question 3.

You manage a risky portfolio with an expected rate of return of 18% and a standard deviation of
28%. The T-bill rate is 8%. Your risky portfolio includes the following investments in the given
proportions:

Suppose that your client decides to invest in your portfolio a proportion y of the total investment
budget so that the overall portfolio will have an expected rate of return of 16%.

a. What is the proportion y?

.16=.08+y(.18-.08)
.16=.08+.1y
.08/.1=y
Y=0.8

b. What are your client’s investment proportions in your three stocks and the T-bill fund?

Stock A=0.8*.25=-.20
Stock B= 0.8*.32=.256
Stock C = 0.8*.43=.344

T-bill = 1 – (.20+.256+.344)
T-bill = 1-(.80)
T-bill=0.20

c. What is the standard deviation of the rate of return on your client’s portfolio?

0.8*.28=.2240=22.50%

Question 4.

Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either
$80,000 or $220,000 with equal probabilities of 0.5. The alternative risk-free investment in T-
bills pays 5% per year.

a. If you require a risk premium of 5%, how much will you be willing to pay for the portfolio?

Cash Flow: (0.5 × $80,000) + (0.5 × 220,000) = $150,000.

With a risk premium of 5% over the risk-free rate of 5%, the required rate of return is 10%.
Therefore, the present value of the portfolio is:

$150,000/1.10 = $136,363.64
 b. Suppose that the portfolio can be purchased for the amount you found in what will be the
expected rate of return on the portfolio?

If the portfolio is purchased for $136,363.64 and provides an expected cash inflow of
$150,000, then the expected rate of return [E(r)] is as follows:

$136,363.64 × [1 + E(r)] = $150,000

Therefore, E(r) = 10%. The portfolio price is set to equate the expected rate of return with the
required rate of return.

c. Now suppose that you require a risk premium of 10%. What price are you willing to pay?

If the risk premium over T-bills is now 10%, then the required return is:

5% + 10% = 15%

The present value of the portfolio is now:

$150,000/1.15 = $130,434.78

Question 5.

Consider a portfolio that offers an expected rate of return of 12% and a standard deviation of
18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of risk aversion for
which the risky portfolio is still preferred to T-bills?

Risky Portfolio Utility

U= .12-0.5*A*.182
U= 0.12 - 0.0162A

T-bill utility
U=.07-(0.5*A*02)
U=.07-0
U=0.07

Rick Aversion calculation

0.12 - 0.0162A > 0.07
A<0.05/0.0162 = 3.09

The risk aversion (A) must be less than 3.09 for the risky portfolio to be preferred to the T-bills.

Question 6.
You manage a risky portfolio with an expected rate of return of 18% and a standard deviation of
28%. The T-bill rate is 8%. Your client’s degree of risk aversion is A = 3.5, assuming a utility
function

a. What proportion, y, of the total investment, should be invested in your fund?

Y=(.18-.08)/3.5*.282

Y=.1/.2744

Y=.3644

b. What are the expected value and standard deviation of the rate of return on your client’s
optimized portfolio?

Expected Return= 0.08*.3644(.18-.08)

=0.08+0.03644
=.1164=11.64%

.3364=Standard Deviation/.28
.3364*.28
Standard Deviation= 10.20%

Question 7.

Investment Management Inc. (IMI) uses the capital market line to make asset allocation
recommendations. IMI derives the following forecasts:

Expected return on the market portfolio: 12%.

Standard deviation on the market portfolio: 20%.

Risk-free rate: 5%.

Samuel Johnson seeks IMI’s advice for a portfolio asset allocation. Johnson informs IMI that he
wants the standard deviation of the portfolio to equal half of the standard deviation for the
market portfolio.

Using the capital market line, what expected return can IMI provide subject to Johnson’s risk
constraint?
E(rc)= .05+(.12-.05)*(0.1/0.2)
E(rc)= 0.05+(0.07*0.05)
E(rc)= 0.05+0.035
E(rc)= 0.085 or 8.5%