UNIVERSITY OF ZIMBABWE

HASC402 FINANCIAL ECONOMICS

ASSIGNMENT 1
DUE DATE: 28-MAY-2021
Attempt all questions

1)
a) What are the main advantages and disadvantages of using variance as a measure of
return compared to Value at Risk [2]
b) Investment returns (% pa), X, on a particular asset are modelled using the probability
Distribution:
X Probability
-10 0.1
5.5 0.9

For a portfolio consisting of ZWL 20million invested in the asset, calculate the
following:
i) Mean [0.5]
ii) Variance [0.5]
iii) 95% VaR over one year [1]
iv) 95% TailVaR over one year [1] [[5]]

Solution
a. See class notes
b.
i. Mean is given by =‐10*0.1+5.5*0.9 = 3.95
ii. Variance = (3.95‐(‐10))2 * 0.1 + (3.95 – 5.5)2 * 0.9 = 21.62
iii. 95% Value at Risk at
VaR(X) = -t where t = max { x : P(X<x) <= 0.05}
P(X<-10) = 0 and P(X< 5.5)= 0.1
t = -10

Since t is a percentage investment return per annum, the 95% value at risk over one
year on a ZWL 20 mil portfolio is 20x0.10 = ZWL 2 mil. This means that we are 95%
certain that we will not make profit of less than ZWL - 2 mil over the next year.

iv. The expected shortfall in returns below -10% is given by

E(min(-10-X,0)) = Σ (-10 - x)P(X=x) x<-10

=0

On a portfolio of ZWL 20 mil, the 95% TailVaR = 0. This means expected reduction in
profit below ZWL -2 mil is zero. That is, profit can not fall below ZWL -2 mil.

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2) Consider the following utility function:
1
𝑈(𝑤) = −
√𝑤

Where U: Utility and w: wealth

a) Derive the expression for the absolute risk aversion and relative risk aversion
measures [1]
b) Assuming that the wealth of the investor increases, interpret the values of the
coefficients of absolute risk aversion and relative risk aversion (as computed in part
a) in terms of investment in risky assets [2]
c) Suppose that the investor (with an initial wealth of ZWL6.5million) is offered the four
following investment portfolios with a payoff in year1 as described below.

Which is the most preferred investment portfolio (if any) of the investor given the
above utility function [2] [[5]]
Solution
a. .

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b. .

c. .

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3)
a) Let U (W) be the utility function of an investor’s wealth, W. The first and second
derivatives of U with respect to W are positives. Explain what these conditions imply
about the investor’s economic characteristics. [2]
b) You are given the following information on projects A and B
State of Nature Probability Return on project Return on project
A A
1 10% -3% -2%
2 20% 4% 4.5%
3 50% 6% 7%
4 20% 12% 14%
Explain with reasons which of the two projects the investor in (i) above should
choose in order to maximise his expected utility of wealth [3] [[5]]

Solution
a..

b..

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4) Assume that a given investor has utility function U (x) = ln(x) and initial wealth of w. Also
assumed that the investor has the option to invest in two assets:
 Risk free asset:- which has a return of zero
 Risky Asset:- which has possible returns as shown in table below
Possible Return R1 R0
probability q 1-q

The investor invests as follows:

 Invests an amount A in the risky asset
 Invests an amount w-A in the risk free asset
a) Express A as a function of x. As the investor’s wealth increases, do you think he will
invest more or less of his portfolio in the risky asset? [1]
b) Assume there is another investor with utility function U(x)= -e-x . . As the investor’s
wealth increases, do you think he will invest more or less of his portfolio in the risky
asset? [2]
𝑈′′(𝑥)
c) What is the coefficient of absolute risk aversion R(x) = - − 𝑈′(𝑥) for the investors and
how do they depend on wealth? How does this explain the differences in answers
obtained in a and b.[2] [[5]]

Solution

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5) An investment market has only two securities A and B such that

Security i Expected return on Variance of return on

security i , Ei security i , Vi
A 2% 4%%
B 5% 9%%

a) Write down the Lagrangian function W when the coefficient of correlation ρAB = 0.25
[1]
b) Write down the first order conditions and solve them to determine the proportions
of the securities in the global minimum variance portfolio [2]
c) Comment on where the efficient frontier lies in expected return-standard deviation
space [2] [[5]]
Solution

a. .

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 b. .

c.

6)
a) Use stochastic dominance to choose between the two assets offering the following
returns:
Return Asset A probability Asset B probability
7% 0.5 0
6% 0.3 0.6
5% 0.5 0.4
[3]

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 b) What are the main advantages and disadvantages of using stochastic dominance to
make investment decisions [2] [[5]]

Solution

a. .

From the above table, ΣpA(7%) > Σp B(7%) but ΣpA(6%) < Σp B(6%) So neither asset first-order
dominates the other. ΣΣpA(7%) > ΣΣp B(7%), ΣΣpA(6%) > ΣΣp B(6%) and ΣΣpA(5%) > ΣΣp B(5%) So
asset B second-order dominates asset A.

b. .
The main advantage of using stochastic dominance to make investment decisions is that the
investor’s utility function need not be explicit and investment decisions can be made for a wide
range of utility functions. The main disadvantage is that it may be unable to choose between
investments and generally compares two investments at a time, thus making it difficult to
choose when considering a large number of available investments.

7) Asset A and B have the following distribution of returns in various states:

State Asset A Asset B Probability
1 10% -2% 0.2
2 8% 15% 0.2
3 25% 0% 0.3
4 -14% 6% 0.3
a) Calculate the correlation between the returns on asset A and asset B [1.5]
b) Calculate the proportion of the assets that should be invested in Asset A to obtain
the minimum risk portfolio [1.5]
c) An investor decides to hold 25% of his wealth in Asset A and 75% in asset B. He is
concerned that the correlation between the assets may not remain constant over
time. Calculate the lowest value of the correlation between assets A and B for which
the investor still gets diversification benefits from holding 25% in Asset A. Assume
that the variances are unchanged. [2] [[5]]

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Solution
a. .

b. .

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 c. .

8) You have the following securities available to you for investment for a single period of 1
year. You are allowed unlimited amount of short-selling in any of the securities also.

Security Expected Return Standard deviation of

return
A 10% 30%
B 15% 40%
C(Risk free) 5% 0%
The following correlations are also given:

ρAB = 0.25 ρBC = 0 ρBC = 0

d. What would be the proportion of A and B in the portfolio to minimise the risk
(measured as variance)? [1]
e. Your target return from the portfolio is 10% for the year. What is the proportion
of A, B and C that will get you the target returns with minimum variance [2]
f. You have invested ZWL100 in the portfolio in part (b). What is the VaR for your
portfolio at a 95% confidence level? State any assumptions(s) that you make. [2]
[[5]]

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Solution

a..

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For any portfolio with a target return Ep, the minimum variance will be achieved when investments
in A and B are in the ratio 1/3.

b..
For a target return of 10% with minimum variance, we use the equation 6 from part (a) and the
result that the ratio of investment between A and B should be 1/3;

c..

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9)
a. Explain what is meant by the multifactor model. You should define any notation you use.
[2]
b.Briefly describe three different types of factor that can be used in a multifactor model [3]

c. An analyst wants to model the returns on 3 securities using a single factor model? He
wants to use market returns as the single factor. What analysis does he need to carry
out to find the parameter needed? [1]
d. The analysis reveals the following for the three securities
Security αi βi SD of the error term
A 3% 1.2 10%
B 2% 0.8 15%
C 5% 0.0 10%
The expected return on the market is 10% and the standard deviation of returns is
20%
i. Calculate the expected returns on securities A,B and C [1]
ii. Calculate the standard deviation of returns for securities A and B [1]
iii. Calculate the covariance between A and B [1]
iv. Is C a risk free security? [1] [[10]

Solution

a. See notes
b. i) Macroeconomic factor models – these use observable economic time series as
factors, e.g. annual rates of inflation, economic growth, short-term interest rates, etc.
ii) Fundamental factor models – these are closely related to the macroeconomic
models but instead of macroeconomic factors, use company specific fundamental
factors, e.g. gearing ratio, P/E ration etc. They may use macroeconomic factors also.
iii) Statistical factor models – these do not rely on specifying factors independently of
the historical returns data. Instead, they use a technique called Principal Components
Analysis to determine a set of indices that can explain as much as possible of the
observed variance.
c. The parameters for the models can be determined using regression of security returns
with the market returns.
d. .

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END

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