Cornell University

AEM 420, Wang, Fall 04

HW2, Diversification
Due Date: 10/5/04

Instructions: Show all relevant calculations. No partial credit will be awarded without legible
accompanying calculations. When using the portfolio optimizer.xls spreadsheet, relevant
calculations will be showing how you determined input parameters, in addition to what the
question requests. The spreadsheet can be found under the Course Tools folder on Blackboard.

1. Portfolio Optimization
The market consists of a riskfree asset with a return of 4%, and five risky assets with returns that
are uncorrelated with each other, each with 20% standard deviation in return, and the expected
returns are 8%, 9%, 10%, 11% and 12%, respectively, for securities A, B, C, D, and E. All
returns and standard deviations are annual. There are no short-selling or leverage constraints.
Get familiar with the Excel spreadsheet (Portfolio Optimizer.xls) to answer the following
questions:

(a) A friend argues that the only risky asset that you should invest in is the one with a 12%
expected return, because “they all have the same standard deviation and the 12% expected return
clearly dominates the expected returns on other assets”. Is he right or wrong? Explain.

(b) What are the weights on each of the risky assets in the optimal portfolio of risky assets only
(“OCRA” portfolio)?

(c) Jane is currently 25 years old and has $100,000 in cash to invest. If she invests 100% of her
wealth in the OCRA, how much will she invest in each security?

(d) Jane’s great-grandfather was the founder of Company A. He has bequeathed 100,000 shares
(the price is $10 per share) to Jane, which will be transferred to her upon her 35th birthday. Jane
cannot short sell any securities including cash. What will be Jane’s effective dollar investments if
she maintained her allocations from (c)? What would her revised optimal dollar investments be
in each security, taking into account her inheritance and assuming she is targeting 8.25%
expected return?

(e) Although Jane cannot short sell Company A shares, is there any way for her to invest her total
wealth in the OCRA? Explain.

(f) Recalculate the OCRA weights if the standard deviation of the security E (which has a 12%
expected return) is 25% instead of 20%.
2. Portfolio Optimization II
(a) The market portfolio has an annualized expect return of 20% and annualized standard
deviation of 30% per annum. Stock A has a standard deviation of 60% per annum and is
uncorrelated with the market portfolio. Its alpha is 5% per annum. The riskless rate of return is
5% per annum. Use the Portfolio Optimizer to find the optimal mix of risky assets when we
construct the OCRA, and give an intuitive explanation for why it is optimal to hold the stock.

(b) The market portfolio has an annualized expect return of 20% and annualized standard
deviation of 30% per annum. Stock A has a market beta of –1, and a standard deviation of 60%
per annum. Its expected return is 1% per annum. The riskless rate of return is 5% per annum. Use
the Portfolio Optimizer to find the optimal mix of risky assets when we construct the OCRA, and
give an intuitive explanation for why it is optimal to hold the stock.

3. Portfolio Optimization with Human Capital Constraint

Jane is an investment banker, and John is a doctor. Both have savings worth $2 million, and both
have income streams with present value worth $1 million. Assume Jane’s human capital is
perfectly correlated with the Financial Sector’s return, and John’s human capital is perfectly
correlated with the Healthcare sector’s return. Both have the same universe of investments
available, shown below, in addition to a riskfree security which pays a rate of 2% per annum. All
sector fund returns are uncorrelated.

Sector Fund Expected Return (%) Standard Deviation (%)

Energy 4 12
Entertainment 6 14
Financial 9 18
Food 4 9
Healthcare 7 15
Retail 6 12
Technology 11 25

(a) What is the Optimal Combination of Risky Assets given no short-selling constraints?

(b) Jane wants a target expected return of 10% for her total wealth. What dollar investments will
she make in each fund and in the riskfree asset? Short selling is not allowed for any assets.

(c) John wants a target expected return of 5% on his total wealth. What dollar investments will
he make in each fund and in the riskfree asset? Short selling is not allowed for any assets.
4. Portfolio optimization for University Endowment Funds
General University and Hi-Tech University both have endowment funds of $3 billion to invest in
sector funds with expected annual returns and annual return standard deviations as shown below:

Sector Fund Expected Return (%) Standard Deviation (%)

Energy 4 12
Entertainment 6 14
Financial 9 18
Food 4 9
Healthcare 7 15
Retail 6 12
Technology 11 25

All sector fund returns are independent. The riskfree rate is 2% per year, though both universities
plan to be fully invested in sector funds. Short selling is not allowed. In addition to the
endowment itself, each university has expected future alumni contributions with present value
$297 million. General University’s students enter jobs in all sectors in exactly the same
proportion as the market. Hi-Tech University’s students all enter Technology sector jobs.

(a) What dollar amount should General University invest in each sector fund if it believes in
diversification? What is the implicit investment in each sector fund considering future alumni
contributions?

(b) What dollar amount should Hi-Tech University invest in each sector fund if it believes in
diversification? What is the implicit investment in each sector fund considering future alumni
contributions?
5. Value at Risk (VaR)
Consider a managed portfolio which has expected return of 20% per annum and return standard
deviation of 60% per annum, in an economy in which the annual riskfree rate is 8%, the expected
return on the market portfolio is 13% per annum, and the return standard deviation of the market
portfolio is 20% per annum. All returns are normally distributed. Determine:

(a) the beta and correlation of the managed portfolio and of the market portfolio, if CAPM holds.

(b) the 1-year, 1%, VaR of a $1 million investment in the managed portfolio, and the 1-year, 1%
VaR of a $1 million investment in the market index.

6. Performance Evaluation, Alpha vs. Sharpe Ratio

The market portfolio has an annual expected return of 15% per annum, and a standard deviation
of 20% per annum. Hedge fund XYZ has a beta of 0, alpha of 3% per annum, and standard
deviation of 10% per annum. The riskless rate is 5% per annum.

(a) Calculate the Sharpe Ratio for the hedge fund and the market as a whole. Assuming
you can only invest in either the market index fund or XYZ, which would you invest
in?

(b) Assume you can invest in both the market index fund and hedge fund XYZ. Use the
portfolio optimizer to determine the optimal portfolio weight in each fund. What is
the Sharpe Ratio of this combination?

(c) What alpha would be required for XYZ to have the same Sharpe Ratio as the market?

7. Invest In What You Know?

The market portfolio has an annual expected return of 15% per annum, and a standard deviation
of 20% per annum. When running a market model regression, hedge fund ABC has a beta of 1.2,
alpha of 2% per annum, and residual (idiosyncratic portion) standard deviation of 18% per
annum. The riskless rate is 5% per annum.

(a) Calculate the Sharpe Ratio for the hedge fund and the market as a whole.

(b) Use the portfolio optimizer to determine the Sharpe Ratio of the optimal combination
of a market index fund and ABC fund.

(c) Respond to the oft-said investment advice, “Invest in what you know”.

(Hint: we obtained the residual standard deviation through regression analysis, meaning
the residual risk and the market portfolio risk are uncorrelated).