Portfolio Management and Performance Evaluation: 4321

University of Minnesota October 8, 2021

Professor Erik Loualiche (eloualic@umn.edu) Problem Set 2

Portfolio Management and Performance Evaluation

Homework 2

Note: Answers must be justified. Correct answers without explanation will not be given credit. The total
points of this homework is 20.

Question (1) (Minimum Variance Frontier with one risk-free asset and one risky asset) (10
points)
Suppose there are two securities in the market with the following characteristics:

Asset E(Ri ) σ(Ri )

F: Risk-Free 5% 0
S: Stock 15% 10%

(a) What is the correlation between the risk-free asset and the stock? Why?
(b) Let Xs be the fraction of the wealth that you invest in the stock (S). As in class, consider a portfolio
P that combines the risk-free F asset and the stock S. Thus the returns on this portfolio are given by
Rp = Xs Rs + (1 − Xs )Rf . What is the expected return on this portfolio P (leave the answer as a
function of Xs )? What is the standard deviation of this portfolio (again leave it as function of Xs)?
(c) What is the Sharpe Ratio of the stock?
(d) What is the equation of the Capital Allocation Line (CAL)? Plot the CAL on the mean-standard
deviation space. Also, make sure that you show where the Stock and the Risk-free asset are on this
CAL. In which region of the CAL are you borrowing? (i.e. mark the part on the CAL for which
Xf < 0). In which region of the CAL are you lending? (i.e. mark the part on the CAL for which
Xf > 0)
(e) Now suppose you have mean variance preferences described by the following utility function:
1
U = E[R] − × A × σ 2 (R)
2
and your risk aversion is A = 0.5. What is your optimal portfolio (i.e. value of Xs ) here? What does
optimal means (i.e. the portfolio is optimal in what sense?) (Hint: you have the formula in the lecture
slides)
(f ) Suppose there is another investor in the market that is more risk-averse than you. The risk aversion
of this agent is A = 1.What is the optimal portfolio of this investor? How does it compares to your
optimal portfolio (i.e. who invests more in stocks?) Does this makes sense to you?

Question (2) (Minimum Variance Frontier with two risky asset) (5 points)
Suppose there are two risky securities in the market with the following characteristics:

Asset E(Ri ) σ(Ri )

D: Dell 16% 20%
I: IBM 10% 15%
2 Handout 2: Portfolio Management and Performance Evaluation

and suppose the correlation between the returns of Dell and IBM is 0.6 (i.e. ρD,I = 0.6)

(a) Let XD be the fraction of the wealth that you invest in Dell. As in class, consider a portfolio P that
combines these two stocks. Thus the returns on this portfolio are given by Rp = XD RD + (1 − XD )RI .
What is the expected return on this portfolio P (leave the answer as a function of XD )? What is the
standard deviation of this portfolio (again leave it as function of XD )?
(b) Using your answer from the previous question, fill the values in the following table:

XD E(Rp ) σ(Rp )
−0.5 ... ...
0 ... ...
0.5 ... ...
1 ... ...
1.5 ... ...

(c) Given the values that you just found out in the previous question, plot the minimum-variance frontier
composed of these two assets (hint: you can easily do this in Excel but if you prefer you can do it by
hand). Which part of this Minimum Variance Frontier is efficient?

(d) What is the ”Minimum Variance Portfolio” (MVP) of these two stocks? Mark this portfolio on the
minimum variance frontier (from previous question).

Question (3) (Minimum Variance Frontier with many risky assets) (5 points)
Suppose there are many risky securities (stocks) in the market. However, you are told that there are two
particularly interesting portfolios of (risky) stocks in the market: portfolios A and B. These two portfolios
have the following characteristics:

Asset E(Ri ) σ(Ri )

A: Portfolio A 10% 5%
B: Portfolio B 15% 14%

And you also know that the correlation between these two portfolios is 0.3. You also know that these
two portfolios ARE on the minimum variance frontier..

(a) Can you construct the minimum variance frontier with the information provided? Why? (i.e. say the
name of the theorem we discussed in class)
(b) Hopefully, you answered yes to the previous question. Sketch the minimum variance frontier of the
market with the information provided. Which part of the minimum variance frontier is efficient? Why?
(c) If you didn’t know that portfolios A and B were on the minimum variance frontier, do you think you
would have been able to sketch the minimum variance frontier easily? (Just briefly explain in words all
the information/data that you would need to have in order to be able to compute/derive the minimum
variance frontier)