Investment Management Questions to Problem Set 2

True-False Questions

1. If share A and share B have a correlation of returns of 0.8, and if share B is very volatile then share A
must also be quite volatile.

2. If two portfolios are both on the mean-variance efficient frontier, then the one that has the higher
expected return will also have the higher volatility.

3. If an investor is risk neutral, then the utility score of a risky portfolio is equal to the expected return
provided by this portfolio.

4. Even if the correlation between the return of two stocks A and B is -1, we cannot combine these stocks
into a portfolio that has zero variance.

Main Questions:

1. Suppose portfolio A has the same average return as portfolio B, and a smaller standard
deviation. Then all investors should prefer A to B. This principle is fundamental in financial
economics. What assumptions underlie this principle? Can you show the mechanics using a
diagram?[hint: You need to think risk aversion and utility theory.

2. Open an Excel spreadsheet, and draw out the indifference curves for two investors, one with
A=2 and another with A=4. Derive the combinations of E(r) and σ that give utility of 0.09.
[hint: You
will need to set σ values, say from 0 to 50%, and then solve for the E(r) that gives U=0.09
for the two investors.

3. If the returns of a stock have an annual total volatility (standard deviation) of 25%, and a
correlation with the market index of 0.3, and the market has an annual volatility (s.d.) of 15%,
what is the beta of the stock, and what is its idiosyncratic risk?

4. Prove that the covariance between the returns of two stocks is β A × β B × σ 2M (where M stands for
the market index, and the betas are the betas of these stocks to M)

5. If two shares each have a beta of 1 and annual volatility (s.d.) of 30% while the market has an
annual volatility of 20%, what is the correlation between each of the shares A and B and the
market (M)? What is covariance of returns of the two shares, and what is the correlation between
the two shares?

6. How many shares would you need to hold in a portfolio to have an annual volatility of no
more than 22%, assuming that they are as in the previous question (volatility of 30%, beta
of 1 and idiosyncratic risk uncorrelated across stocks)? Assume that each share receives an
equal weight of 1/N in the portfolio.
7. In the previous question, what happens to portfolio variance as N gets larger?

8. Stock A has an expected return of 13%, a beta with respect to the market index of 0.8 and
a firm-specific standard deviation of returns equal to 30%. The corresponding numbers for
stock B are 18%, 1.2 and 40%. The market index as a standard deviation of 22% and the
risk-free rate is 8%.

a. What are the standard deviations of the returns of A and B (i.e., the total variance)?

b. Assume we construct a portfolio, putting a weight of 0.3 on A, of 0.45 on B and 0.25

on the risk-free asset. Compute the expected return, standard deviation, beta and non-
systematic risk (s.d.) of the portfolio.

9. Stock S has an expected return of 20% and standard deviation of 30%. Stock C has an
expected return of 12% and a standard deviation of 15%. The correlation between the
return of the two stocks is 0.1. What are the weights on these stocks in the minimum-
variance portfolio, and what is this portfolio expected return and standard deviation?

10. Exercise using Excel (try at home by your self): In excel spreadsheet Question 10 you are
given some data for 6 stocks and the market index. Assume that you have conducted
security level analysis on these stocks, and you have estimates for their alphas. Implement
active portfolio management using the single factor model, and calculate the improvement
in the Sharpe ratio that results from this active management.

[You need to use the information in Panels A to D to find the optimal weight on the active
portfolio, the weight on the individual stocks in the active portfolio, and then calculate the
information ratio. You need to basically fill Panel E. This information is in found the
lecture notes that accompany the live lecture we had in week 2].

[Note that the worksheet Q10_data contains the raw returns data used to produce the
numbers in Panels A to D. You do not need to use these numbers, but it would be good to
see how the statistics in the other worksheet are calculated.]

[Note that even though the assessment methods for this module do not require using Excel,
it is crucial as an investment manager to be comfortable with data. So, this type of
exercises are a good way to practice using Excel. Moreover, the theory that the question is
based on (active portfolio management and information ratio) is part of the module, and
this it is important to learn how to use the formulas we have discussed in class to do
calculations].