FNCE 201 Session 2 Modern Portfolio Theory

Tutorial questions and solutions (Version 2 Updates on 26-AUG)

1. Calculate expected return and standard deviation of the portfolio:

Stock Bond
Expected return 6% 3%
Standard deviation 20% 5%
Weights 50% 50%
Correlation = 0.4
Risk free rate = 2%

2. Using your answer to Q1, calculate the Sharpe ratio of the portfolio. Compare the Sharpe ratio of
the portfolio to the Sharpe ratio of the stock and bond. Explain why the Shape ratio of the portfolio
is different than the Sharpe ratio of the individual stock and bond.

3. If the correlation of the stock and bond were to increase:

a. Would the expected return of the portfolio rise or fall?
b. Would the volatility of the portfolio rise or fall?

4. A portfolio contains two risky assets. The diversification benefit of the portfolio will increase when:
a. Correlation between the two assets increases towards 1
b. Risk-free rate decreases
c. Expected return of both assets increase

Which of the above statements are true? Consider each statement independently (assume all else
equal).

5. Which of the following statements are true:

a. The market portfolio must be on the efficient frontier.
b. Portfolios on the efficient frontier have the highest possible Sharpe Ratio for a given level of
portfolio risk (standard deviation).
c. The market portfolio has a beta equal to one.

Which of the above statements are true? Consider each statement independently.

6. Assume the CAPM holds. Consider each scenario independently. Which of the scenarios is/are
possible.
Scenario 1 Scenario 2
E(Return) Beta E(Return) 
Stock ABC 20% 1.4 Market portfolio 30% 35%
Stock XYZ 25% 1.2 Stock XYZ 40% 25%

7. Assume the CAPM holds. Consider each scenario independently. Which of the scenarios
is/are possible.
Scenario 1 Scenario 2
E(Return) σ E(Return) σ
Risk-free 10% 0% Risk-free 10% 0%
Market portfolio 18% 24% Market portfolio 18% 24%
Portfolio XYZ 20% 30% Portfolio ABC 20% 30%40%
FNCE 201 Session 2 Modern Portfolio Theory
Tutorial questions and solutions (Version 2 Updates on 26-AUG)

8. Assume the CAPM holds. Calculate the expected return of a stock with a beta of 1.5 if the
market risk premium is 4% and the risk-free rate is 2%.

9. Assume the CAPM holds. Calculate the expected return on the market portfolio if risk-free
rate is 2% and a stock with a beta of 0.8 has an expected return of 5%.

10. Which of the following are examples of investment frictions?

a. China A shares are shares of stock traded on the Shanghai and Shenzhen stock
exchange that with a few exceptions can be own by mainland citizens.
b. University endowments must pay out 5% of assets under management each year to
finance the university operations
c. Some government bonds currently have negative interest rates.
FNCE 201 Session 2 Modern Portfolio Theory
Tutorial questions and solutions (Version 2 Updates on 26-AUG)

Solutions
1. Expected return=6%x0.5+3%x0.5=4.5%
Standard deviation=sqrt(0.5^2x0.2^2+0.5^2x0.0.5^2+2x0.5x0.2x0.5x0.05)=11.24%
Standard deviation=sqrt(0.5^2x0.2^2+0.5^2x0.05^2+2x0.5x0.5x0.2x0.2x0.05)=11.24%
2. Sharpe of portfolio=(0.045-0.02)/0.1124=0.22
Sharpe of stock=(0.06-0.02)/0.2=0.2
Sharpe of bond=(0.03-0.02)/0.05=0.2
Since the stock and bond are not perfectly correlated, there are diversification benefits when they are
combined in a portfolio. Specifically, it is diversifying away idiosyncratic risk. Therefore, the Sharpe ratio of the
portfolio is higher than the Sharpe ratio of each individual stock or bond alone.
3. The correlation does not affect the expected return. It will increase the volatility because there are less
benefits to diversification.
4. A. False. Diversification benefits increase as correlation falls
B. False. Risk free rate does not affect the volatility of the portfolio
C. False. Expected return does not affect the volatility of the portfolio
5. A. True. It is the tangency portfolio
B. False. Portfolios on the CML have the highest possible Sharpe Ratios
C. True. Finance 101.
6. Scenario 1. Not possible. Stock XYZ has a higher expected return but a lower Beta than Stock AB. Scenario 2.
Not possible. Stock XYZ has a higher expected return but lower standard deviation than the market portfolio.
7. Scenario 1. Possible. Portfolio XYZ has the same Sharpe ratio as the market portfolio. To achieve this
portfolio, an investors would borrow at the risk free rate and invest the funds into the market portfolio.
Therefore the weight in the market portfolio will be > 100% and the weight in the risk free rate will be < 0%
(to represent a liability)
Scenario 2. Possible. Portfolio ABC sharpe ratio < Market portfolio. This implies that the portfolio is not
located on the SML.
8. 2%+1.5x4%=8%
9. 5%=2%+0.8(Rm-rf) Rm=(5%-2%)/0.8+2%=5.75%
10. A. Friction. This investbility constraint limits the types of investors that can own equities. This suggests that
companies in China cannot tap on the international capital of equity investors.
B. Friction. University endowments must hold some relatively liquid investments or investments that make
regular payouts to meet this requirement. This friction may affect whether they own a portfolio on the CML.
C. Not a friction. This reflects a current economic environment.

Article discussion questions

1. What types of assets did the Stanford Management Company identify as having (1) high
expected returns and (2) historically low correlations with equity markets? Why did the benefits
of diversification disappear during the 2008-2009 financial crisis?

2. The Stanford Management Company “finds a place on the efficient frontier that meets our long term
objective.” What can we infer about the Sharpe Ratio of the fund? (Hint: Consider the CML)

3. What are some investment frictions that the Stanford Management company faces?