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IN-CLASS EXERCISE 1
A customer relationship manager in Commonwealth Bank obtained the following
information in the bank database regarding 2 of his clients:
Client X Client Z
Portfolio Risk Premium 4.40%
Portfolio Standard Deviation 12.10%
Risk Aversion Level 1.0
Borrowing Rate R f + 0.5% R f + 1%

Commonwealth Bank always offers the following portfolio to all clients as such
portfolio can optimize the reward-to-volatility ratio among all different combinations of
stock A and stock B:
Expected
Return Weight
Stock A 12% 150%
Stock B 6% -50%
The portfolio offered to all clients has a risk premium of 8%.

The relationship manager will meet with Client Z next week to review the client
portfolio composition. What risk premium and the standard deviation the relationship
manager should inform to Client Z regarding the portfolio composition?
E(R C,Z ) − R f = 𝟏𝟏. 𝟏𝟓%

σC,Z = 𝟑𝟏. 𝟗%

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SELF-STUDY PROBLEM SET 1

Which one of the following portfolios cannot lie on the efficient frontier as described by
Markowitz?
Portfolio Expected Return (%) Standard Deviation (%)
a. W 15 36
b. X 12 15
c. Z 5 7
d. Y 9 21

SELF-STUDY PROBLEM SET 2

When adding real estate to an asset allocation program that currently includes only stocks,
bonds, and cash, which of the properties of real estate returns affect portfolio risk? (You can
choose more than one answer in this problem set.)
a. Standard deviation.
b. Expected return.
c. Correlation with returns of the other asset classes.

SELF-STUDY PROBLEM SET 3

Which of the following statements about the global minimum variance portfolio of all risky
securities are valid?
a. Its variance must be lower than those of all other securities or portfolios.
b. Its expected return can be lower than the risk-free rate.
c. It may be the optimal risky portfolio.
d. It must include all individual securities including the risk-free asset.

SELF-STUDY PROBLEM SET 4

Stocks A, B, and C have the same expected return and standard deviation. The following
table shows the correlations between the returns on these stocks.

Given these correlations, the portfolio constructed from these stocks having the lowest risk
is a portfolio:
a. Equally invested in stocks A and B.
b. Equally invested in stocks A and C.
c. Equally invested in stocks B and C.
d. Totally invested in stock C.

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SELF-STUDY PROBLEM SET 5

The correlation coefficients between pairs of stocks are as follows: ρAB = 0.85; ρAC = 0.60;
ρAD = 0.45. Each stock has an expected return of 8% and a standard deviation of 20%.
i. If your entire portfolio is now composed of stock A and you can add some of only one
stock to your portfolio, you would choose:
a. B.
b. C.
c. D.
d. Need more data.

ii. Suppose that in addition to investing in one more stock you can invest in T-bills as well.
Would you change your answers to Part i if the T-bill rate is 8%?
The risky portfolio is at 8%, so the optimal CAL runs from the risk-free rate
through MVP. This implies risk-averse investors will just hold T-Bills.

SELF-STUDY PROBLEM SET 6

The standard deviation of the portfolio is always equal to the weighted average of the
standard deviations of the assets in the portfolio. True or False?
False. The portfolio standard deviation equals the weighted average of the
component-asset standard deviations only in the special case that all assets are
perfectly positively correlated. Otherwise, as the formula for portfolio
standard deviation shows, the portfolio standard deviation is less than the
weighted average of the component-asset standard deviations. The portfolio
variance is a weighted sum of the elements in the covariance matrix, with the
products of the portfolio proportions as weights.

SELF-STUDY PROBLEM SET 7

A pension fund manager is considering two mutual funds and a default free asset. The first
is a stock fund, the second is a long-term government and corporate bond fund, and the third
is a T-bill that yields a rate of 8%. The probability distribution of the risky funds is as
follows:
Expected Return Standard Deviation
Stock fund (S) 20% 30%
Bond fund (B) 12% 15%
The correlation between the fund returns is 0.1

a. Tabulate and draw the investment opportunity set of the two risky funds. Use
investment proportions for the stock fund of zero to 100% in increments of 20%.

Proportion in Proportion in Expected Standard

stock fund bond fund return Deviation
0.00% 100.00% 12.00% 15.00%
20.00% 80.00% 13.60% 13.94%

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40.00% 60.00% 15.20% 15.70%

60.00% 40.00% 16.80% 19.53%
80.00% 20.00% 18.40% 24.48%
100.00% 0.00% 20.00% 30.00%

Graph shown below.

25.00

INVESTMENT OPPORTUNITY SET

20.00 CML

Tangency
Portfolio
Efficient frontier
15.00 of risky assets

10.00 Minimum
Variance
rf = 8.00 Portfolio

5.00

0.00
0.00 5.00 10.00 15.00 20.00 25.00 30.00

b. It is discovered that the weight of stock fund that yields the tangency portfolio (P) is
45.16%, what is the expected return and standard deviation of the tangency portfolio
(P)?

E(R p ) = wS E(R S ) + wB E(R B )

= 45.16% × 20% + (1 − 45.16%) × 12%
= 𝟏𝟓. 𝟔𝟏%

σP = √wS2 σ2S + wB2 σ2B + 2wS wB Cov(R S , R B )

= √45.16%2 × 30%2 + 54.84%2 × 15%2 + 2 × 45.16% × 54.84% × (0.1 × 30% × 15%)
= 𝟏𝟔. 𝟓𝟒%

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c. What is the reward-to-volatility ratio of the best feasible CAL?

E(R P ) − R f
Sp =
σP
15.61% − 8%
=
16.54%
= 𝟎. 𝟒𝟔𝟎𝟏

d. You require that your portfolio yield an expected return of 14%, and that it be efficient,
on the best feasible CAL.
i. What is the proportion invested in the T-bill fund and each of the two risky
funds?
E(R c ) = y E(R p ) + (1 − y)R f
E(R c ) = R f + y[E(R p ) − R f ]
14% = 8% + y[15.61 − 8%]

y = 78.84%

Proportion invested in T − bills

= (1 − y)
= 1 − 78.84%
= 𝟐𝟏. 𝟏𝟔%

Proportion invested in stock

= 78.84% × 45.16%
= 𝟑𝟓. 𝟔𝟎%

Proportion invested in bond

= 78.84% × 54.84%
= 𝟎. 𝟒𝟑𝟐𝟒

ii. What is the standard deviation of your portfolio?

σC = yσp
= 78.84% × 16.54%
= 𝟏𝟑. 𝟎𝟒%

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e. If you were to use only the two risky funds, and still require an expected return of 14%,
what would be the investment proportions of your portfolio? Compare its standard
deviation to that of the optimized portfolio in d) ii, What do you conclude?
14% = 20% × wS + 12% × (1 − wS )
wS = 𝟐𝟓%
wB = (1 − wS ) = 𝟕𝟓%

σP = √wS2 σ2S + wB2 σ2B + 2wS wB Cov(R S , R B )

= √25%2 × 30%2 + 75%2 × 15%2 + 2 × 45.16% × 54.84% × (0.1 × 30% × 15%)

= 𝟏𝟒. 𝟏𝟑%

This is considerably greater than the standard deviation of 13.04% achieved

using T-bills and the optimal portfolio.

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SELF-STUDY PROBLEM SET 8

Abigail Grace has a $900,000 fully diversified portfolio. She subsequently inherits ABC
Company common stock worth $100,000. Her financial adviser provided her with the
following forecast information:

The correlation coefficient of ABC stock returns with the original portfolio returns is 0.40.
a. The inheritance changes Grace’s overall portfolio and she is deciding whether to keep the
ABC stock. Assuming Grace keeps the ABC stock, calculate the:
i. Expected return of her new portfolio which includes the ABC stock.
ii. Covariance of ABC stock returns with the original portfolio returns.
iii. Standard deviation of her new portfolio which includes the ABC stock.
i. E(RNP) = wOP E(ROP ) + wABC E(RABC ) = (0.9  0.0067) + (0.1  0.0125) = 0.728%
ii. Cov = ρ  OP  ABC = 0.40  0.0237  0.0295 = 0.00028
iii. NP = [wOP2 OP2 + wABC2 ABC2 + 2 wOP wABC (CovOP , ABC)]1/2
= [(0.9 2  0.02372) + (0.12  0.02952) + (2  0.9  0.1  0.00028)]1/2
= 2.27%

b. If Grace sells the ABC stock, she will invest the proceeds in risk-free government
securities yielding 0 .42% monthly. Assuming Grace sells the ABC stock and replaces it
with the government securities, calculate the
i. Expected return of her new portfolio, which includes the government securities.
ii. Covariance of the government security returns with the original portfolio returns.
iii. Standard deviation of her new portfolio, which includes the government securities.
Subscript OP refers to the original portfolio, GS to government securities, and NP to
the new portfolio.
i. E(RNP) = wOP E(ROP ) + wGS E(RGS ) = (0.9  0.0067) + (0.1  0.0042) = 0.645%
ii. Cov = ρ  OP  GS = 0  2.37%  0 = 0
iii. NP = [wOP2 OP2 + wGS2 GS2 + 2 wOP wGS (CovOP , GS)]1/2
= [(0.92  0.02372) + (0.12  0) + (2  0.9  0.1  0)]1/2
= 2.13%

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c. Based on conversations with her husband, Grace is considering selling the $100,000 of
ABC stock and acquiring $100,000 of XYZ Company common stock instead. XYZ stock
has the same expected return and standard deviation as ABC stock. Her husband
comments, “It doesn’t matter whether you keep all of the ABC stock or replace it with
$100,000 of XYZ stock.” State whether her husband’s comment is correct or incorrect.
Justify your response.
The comment is not correct. Although the respective standard deviations and expected
returns for the two securities under consideration are equal, the covariances between
each security and the original portfolio are unknown, making it impossible to draw the
conclusion stated. For instance, if the covariances are different, selecting one security
over the other may result in a lower standard deviation for the portfolio as a whole. In
such a case, that security would be the preferred investment, assuming all other factors
are equal.

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