Professional Documents
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4. Calculate the expected return on a stock that has a 30 percent probability of a 30 percent
expected return, a 20 percent probability of a 40 percent expected return, and a 50 percent
probability of a 15 percent expected return.
A. 15 percent
B. 35.5 percent
C. 24.5 percent
D. 20 percent
Level of difficulty: Medium
Solution: C. Expected return = 0.3(30%) + 0.2(40%) + 0.5(15%) = 24.5%
8. Which of the following correlation coefficients will provide the greatest diversification
benefits for a given portfolio?
A. 0
B. 0.5
C. 1
D. –0.9
Level of difficulty: Medium
Solution: D
The lower the correlation coefficient, the lower the portfolio standard deviation. Therefore
the lowest correlation coefficient (-0.9) achieves the greatest diversification.
Practice Problems
11. Describe when to use the arithmetic average and when to should use the geometric mean to
describe a return series.
Level of difficulty: Easy
Solution: We use arithmetic average when we are trying to estimate the typical return for a
single time period, such as a month or a year. However, we should use the geometric mean
when we are interested in determining the “true” average rate of return over multiple periods
so that it reflects the compound rate of growth over time (i.e., the realized change in wealth
over multiple periods).
12. State three of the most important assumptions underlying Markowitz’s notion of efficient
portfolios.
Level of difficulty: Easy
Solution:
1. Investors are rational decision-makers.
13. The Absent Minded Professors’ file on the daily performance of the JellyBean Company has
been partially completed. Fill in the missing data.
Level of difficulty: Easy
Solution:
Tu $115 $2 7%
14. The Absent Minded Professors have conducted an extensive analysis of the economy and
have concluded that the probability of a recession next year is 25%, a boom is 15% and a
stable economy is 60%. Your boss has estimated that the price of the XPK Company will be
$60 if there is a recession, $110 if there is a boom and $85 if the economy is stable.
Currently, XPK is trading for $75. Calculate the ex-ante expected return on XPK.
Level of difficulty: Easy
Solution:
Calculate the expected price: .25*$60 + .15*$110 + .60*$85 = $82.50
Expected return = (82.50 / 75) –1 = 10%
15. You have observed the following returns: 10 percent, –8 percent, 5 percent, 2 percent and –
20 percent
A. Calculate the geometric average return
B. Calculate the arithmetic average return
C. Calculate the variance and standard deviation of returns
Level of difficulty: Easy
Solution:
B. and C.
Using the BAII+ data function to answer B. and C:
2nd DATA
2nd CLR WORK
Sample variance is the sample standard deviation squared = 0.014220. Note: if we just square
11.92476, we get 142.20 percent squared!
16. On Monday you invested $175 in the Alligator Dental Floss Company. ADFC has earned
daily returns of 7 percent, 19 percent, -45 percent (the Alligator ate the CEO that day), 3
percent, and 10 percent. What is the value of your investment at the end of the five days?
Level of difficulty: Easy
Solution:
Value at the end of 5 days = $175*(1+.07)(1+.19)(1-.45)(1+.03)(1+.10) = $138.85
17. You have observed the following daily returns for two companies: ABC and DEF.
Daily Returns
ABC DEF
Monday 3% 2%
Tuesday 2% 8%
Wednesday -8% 14%
Thursday -10% 12%
Friday 7% 3%
DEF: 7.6953%
Remember, you can always go back and check that you have entered the correct data by
using the up arrow key.
Using the BAII+ memory (your stored the data using the STO function),
18. The Absent Minded Professors are exploring different portfolio allocations between two
stocks. Complete the following table.
Expected return
3% 6% 10%
of Stock 2
19. Your portfolio consists of two securities: Ice-T and Mr.B. The expected returns for Ice-T are
8% and while for Mr.B it is 3%. The standard deviation for Ice-T is 4% and is 14% for Mr.B.
If 15% of the portfolio is invested in Ice-T, calculate the portfolio standard deviation if:
A. The correlation between the stocks is .75
B. The correlation between the stocks if -.75
Level of difficulty: Easy
Solution:
A. The correlation between the stocks is .75
20. The Absent Minded Professors are exploring the risk of different portfolio allocations
between two stocks and have partially completed the following table. Your task is to complete
the table.
Case 1 Case 2
Case 1 Case 2
Weight in Stock 1 75% 15%
Weight in Stock 2 25% 85%
Standard deviation of
15% 2%
Stock 1
Standard deviation of
3% 10%
Stock 2
Covariance between -0.2*.15*.03 .40*.02*.10
Stocks 1 and 2 = -.0009 = 0.0008
Correlation between
-.20 .40
Stocks 1 and 2
Portfolio Variance 0.012375
Portfolio Standard
11.1243%
Deviation
A. Graph the returns of each stock (ABC, DEF, GHI, JKL and MNO) against the returns of
XYZ.
C. Based on the five graphs, which stocks are negatively correlated with XYZ?
D. Based on the five graphs, which stocks are uncorrelated with XYZ?
MNO appears to have a low correlation with XYZ (it goes up and down as XYZ increases).
E. Calculate the correlation between the five stocks and XYZ to check your results from parts
(B) to (D).
Using the data analysis feature of Excel (see Problem 31), we get the following correlation
matrix:
Correlation
with XYZ
ABC 1
DEF 0.999133
GHI -0.84867
JKL -0.99485
MNO -0.13484
Your results, based on the graphs, is consistent with the calculated correlations.
22. Calculate the annual arithmetic average and geometric mean return on the following security,
and state which method is more appropriate for the situation: purchase price = $30; first year
dividend = $5; price after one year = $35; second-year dividend = $8; selling price after two
years = $28.
Level of difficulty: Medium
Solution:
Total return (year 1) = (35+5–30)/30 = 33.3%
Total return (year 2) = (28+8–35)/35 = 2.9%
AA = (33.3%+2.9%)/2 = 18.1%
G = [(1+.333)(1+.029)]1/2 – 1 = 17.12%
Geometric mean is more appropriate here because it reflects the true average return over
multiple periods.
23. Calculate the ex post standard deviation of returns for the following: 50 percent, 30 percent,
20 percent, 35 percent, 55 percent.
Level of difficulty: Medium
Solution:
= (50%+ 30%+ 20%+ 35%+ 55%)/5 = 38%
24. An investor owns a portfolio of $30,000 that contains $10,000 in Stock A, with an expected
return of 12 percent; $5,000 in bonds, with an expected return of 8 percent; and the rest in
Stock B, with an expected return of 20 percent. Calculate the expected return of his portfolio.
25. On January 1, 2006, the Absent Minded Professors published the following forecasts for the
economy:
State of the
Probability Forecasted quarterly returns
economy
Poor 20% -3%
Average 50% 5%
Boom 30% 8%
During 2006, you observed quarterly returns of 2 percent, –5 percent, 3 percent and 8
percent.
A. Calculate the ex-ante expected quarterly return
B. Calculate the ex-ante standard deviation of quarterly returns
C. Calculate the ex-post average quarterly return
D. Calculate the ex-post standard deviation of quarterly returns
E. Explain the difference between the ex-ante and ex-post returns
Level of difficulty: Medium
Solution:
Note, we cannot say the variance is 0.15%. If the returns are measured in percent (i.e.
8%) then the units of the variance are percent squared which is difficult to interpret. In
contrast, the units of standard deviation are the same as the units of return.
Using the BAII+ Data function (this will be very useful for standard deviations and
covariances!)
BAII+ keystrokes:
2nd DATA (the 7 key) opens the data sheet
2nd CLR WORK
X01 = 2% <ENTER>
↓
Y01 = 1% (make sure not to enter any of the quarterly returns in Y, don’t need to hit
enter as you are not using the Y because you only have one variable)
↓
X02 = -5%, Y02 = 1, X3 = 3%, Y03 = 1, X04 = 8%, Y04 = 1
2nd STAT
The BAII+ should say LIN (if it does not, just go 2nd SET until it reads LIN)
↓
BAII+ indicates N = 4.0
This indicates that the sample size is 4
↓
BAII+ indicates
This is the mean of the quarterly returns in percent. If you entered the data as .02, -.05
etc, then the mean will be .02.
↓
BAII+ indicates
This is the sample standard deviation in percent
↓
BAII+ indicates
This is the population standard deviation in percent
26. On January 1, The Absent Minded Profs have completed their analysis of the prospects for
the Geriatric Toy Store and have concluded that that there is a 15 percent chance that the
stock price will be $200 in 1 year while there is an 85 percent chance that the stock price will
be $45. Six months later, the Profs revised their estimated probabilities to 35 percent chance
of the high state (stock price of $200). If the market agrees with the Profs revised
probabilities, what is the expected change in stock price from January 1 to July 1? Assume
the discount rate is zero.
Level of difficulty: Medium
Solution:
January 1st: the expected price of GTS in one year is .15*200+.85*45 = $68.25
If the market agrees with the Profs analysis, then we would expect the stock price to be
$68.25 discounted back to January 1st. As the discount rate is zero, the expected price on
January 1st is $68.25.
July 1st: the expectations about GTS have changed so we need to determine the new expected
price in six months: .35*200+.65*45 = $99.25
If the market agrees with the Profs, then the expected price on July 1st will be $99.25
27 As an analyst for the Absent Minded Profs, ADFC is one of the firms that you are responsible
for. Currently, you have a “hold” recommendation21 on ADFC. The current price of ADFC
is $138.85. You have conducted an extensive analysis of the industry and you feel that the
probability that the firm will capture a substantial share of the new market is 35 percent, and
the stock price would rise to $250 due to the unusually high growth rate of future earnings.
You are expecting earnings to grow at a rate of 45 percent per year for the next five years if
the firm is able to capture the new market. However, you feel that there is a 40 percent
probability that the firm will face serious difficulties in the near future, in which case the
stock price will fall to $14.85 and the earnings growth rate will drop to 3 percent. There is a
25 percent chance that nothing will change for the firm and their earnings growth rate will
remain at 12 percent. Should you change your recommendation?
Level of difficulty: Medium
Solution:
To determine what the recommendation should be, we need to determine the expected price
in the future: .35*250+.40*14.85+.25*138.85 = $128.1525.
The recommendation should be changed to “sell” – at the current price of $138.85, the stock
is overpriced.
29. The Absent Minded Professors are interested in the tradeoff between investing in two stocks:
Xfoot and Ytoe. The expected return on Xfoot is 6 percent and Ytoe is 18 percent.
Level of difficulty: Medium
Solution:
A. Graph the relationship between the expected return on the portfolio and the weight in
Ytoe.
Weight in Portfolio
Ytoe return
0% 6.00%
1% 6.12%
2% 6.24%
3% 6.36%
99% 17.88%
100% 18.00%
C. Your boss has just looked at your results and disagrees. He says the tradeoff between Ytoe
and Xfoot is negative and therefore, your results are wrong. Explain to your boss how
you are both correct.
My boss and I are both correct. For every 1% decline in the investment in Ytoe, I will be
gaining .01*6% and giving up .01*18% for a net decrease of 0.12%. If we look at the
graph, I’m increasing the weight in Ytoe (the higher expected return security). My boss is
increasing the weight in Xfoot (the lower expected return security) and consequently his
number must be the negative of mine. On the graph, I am moving to the right while my
boss is moving to the left. Using calculus, my boss took the derivative with respect to (1-
w) while I took the derivative with respect to w.
30. You have observed the following monthly returns for ABC and DEF.
Monthly returns
ABC DEF
January 6% 1%
February -3% 3%
March -2% 5%
April -1% 7%
May 0% 2%
June 3% 1%
July 4% -3%
August 8% -2%
September 5% -4%
October 3% -2%
November 4% 1%
December 5% 2%
A. Graph the relationship between the weight in ABC and the portfolio returns (restrict all
weights to be greater than or equal to zero)
B. Graph the relationship between the weight in ABC and the portfolio standard deviation
(use the same weights as in a).
C. Using the data you have created in a) and b), graph the relationship between the risk and
return for the portfolio (put return on the Y axis).
D. Which portfolio weights do you prefer and why?
Level of difficulty: Medium
Solution:
To do this, we will use Excel and begin by calculating the average monthly return and then
graph the portfolio average return as a function of alternative weights.
ABC DEF
Average 2.67% 0.092%
Stdeviation 3.42% 3.26%
Row A B C
/Col
1 Monthly returns
2 ABC DEF
3 January 0.06 0.01
4 February -0.03 0.03
… … … …
14 December 0.05 0.02
15
16 Average =AVERAGE(B3:B14) =AVERAGE(C3:C14)
17 Stdeviation =STDEV(B3:B14) = STDEV (C3:C14)
B. Graph the relationship between the weight in ABC and the portfolio standard deviation
(use the same weights as in a).
To graph the portfolio standard deviation we need either the sample covariance or
correlation. To do this we will use the data analysis feature in Excel.
ABC DEF
ABC 1
DEF -0.70389 1
The result is the correlation matrix. The correlation between ABC and DEF is -.70389. Note:
if you used the covariance function in excel, you will get the population covariance and will
need to correct to a sample covariance (multiply by n/(n-1); remember from statistics that
when you are calculating the variance or covariance with sample data, you divide by n–1. If
you are working with a population, you divide by n).
ABC DEF
Standard deviation 3.42% 3.26%
Correlation -0.70389
Row/
Col A B C
1 ABC DEF
Standard
2 deviation 0.0342 0.0326
3
4 Correlation -0.70389
5
6
Weight in Weight in
7 ABC DEF Portfolio standard deviation
8 0 =1-A8 =(A8^2*B$2^2+B8^2*C$2^2+2*C$4*A8*B8*B$2*C$2)^0.5
9 =0.1+A8 =1-A9 =(A9^2*B$2^2+B9^2*C$2^2+2*C$4*A9*B9*B$2*C$2)^0.5
10 =0.1+A9 =1-A10 =(A10^2*B$2^2+B10^2*C$2^2+2*C$4*A10*B10*B$2*C$2)^0.5
11 =0.1+A10 =1-A11 =(A11^2*B$2^2+B11^2*C$2^2+2*C$4*A11*B11*B$2*C$2)^0.5
… and so on
Note the linear relationship between the return and the portfolio weight and the nonlinear
relationship between the standard deviation and the portfolio weight.
C. Using the data you have created in a) and b), graph the relationship between the risk and
return for the portfolio (put return on the Y axis).
31. The Absent Minded Professors wish to combine two stocks: Encor and Maestro, into a
portfolio with an expected return of 16 percent. The expected return of Encor is 2 percent
and the standard deviation of 1 percent. The expected return of Maestro is 25 percent with a
standard deviation of 10 percent. The correlation between the two stocks is 0.40.
A. What is the composition (weights) of the portfolio?
B. What is the portfolio standard deviation?
Level of difficulty: Medium
Solution:
A. What is the composition (weights) of the portfolio?
Set w = weight in Encor
32. The Absent Minded Professors wish to combine two stocks: Peledon and Mexcor, into a
portfolio with an expected return of 16%. The expected return of Peledon is 2% and the
standard deviation of 1%. The expected return of Mexcor is 25% with a standard deviation of
10%. The correlation between the two stocks is 0.40.
A. What is the composition (weights) of the portfolio?
B. What is the portfolio standard deviation?
Level of difficulty: Medium
Solution:
A. What is the composition (weights) of the portfolio?
Set w = weight in Peledon
33. The Grumpy Old Analysts have recently published a study claiming that the benefits to
diversification are constant. In other words, adding one more stock to a 3 stock portfolio will
have the same impact as adding 1 more stock to a 500 stock portfolio. The Absent Minded
Profs are not convinced and give you the task of evaluating the GOA claim.
A. Assume that all the stocks have the same standard deviation, 10%, and all are independent
(correlation equals 0.00). Create equally weighted portfolios of 1, 2, 3, … stocks and
calculate the portfolio standard deviation for each portfolio. Graph the portfolio standard
deviation as a function of the number of stocks. Based on the results of your analysis,
evaluate the Grumpy Old Analysts claim.
B. As the number of firms increases, what do you expect to happen to the risk of the
portfolio? Can the risk of the portfolio become close to zero?
Level of difficulty: Medium
Solution:
A. Sample data from Excel:
Row
/col A B
Number of
1 stocks Stdev of portfolio
2 1 =(A2*(1/A2)^2*0.1^2)^0.5
3 =1+A2 =(A3*(1/A3)^2*0.1^2)^0.5
4 =1+A3 =(A4*(1/A4)^2*0.1^2)^0.5
5 =1+A4 =(A5*(1/A5)^2*0.1^2)^0.5
6 =1+A5 =(A6*(1/A6)^2*0.1^2)^0.5
7 =1+A6 =(A7*(1/A7)^2*0.1^2)^0.5
8 =1+A7 =(A8*(1/A8)^2*0.1^2)^0.5
9 =1+A8 =(A9*(1/A9)^2*0.1^2)^0.5
10 =1+A9 =(A10*(1/A10)^2*0.1^2)^0.5
11 =1+A10 =(A11*(1/A11)^2*0.1^2)^0.5
From the graph it is obvious that the decline in portfolio risk decreases as we add more
stocks to the portfolio – when we go from one to two stocks, the risk decreases by by
almost 30% (from 10% to 7.07%), however, when we go from two to three, the decrease
is less than 20% (from 7.07% to 5.77%).
34. Calculate the covariance and correlation coefficient of a portfolio that has 40 percent in
Stock X, with an expected return of 40 percent and standard deviation of 12 percent; and
60 percent in Stock Y, with an expected return of 30 percent and standard deviation of
15 percent. The portfolio standard deviation is 6 percent.
Level of difficulty: Medium
Solution:
36 = 23.04+81+0.48 COVX,Y
COVX,Y = -141.75 %2
= = -0.7875
35. Calculate the correlation coefficient (ρAB) for the following situation:
36. To achieve a zero standard deviation for a portfolio, calculate the weights of Stock A and
Stock B in Problem 35 by assuming the correlation coefficient is–1.
Level of difficulty: Difficult
Solution:
37. An investor purchased 500 shares of Stock A at $22 per share and 1,000 shares of Stock B at
$30 per share one year ago. Stock A and Stock B paid quarterly dividends of $2 per share
and $1.5 per share, respectively, during the year. One year later, the investor sold both stocks
at $30 per share. Calculate the total return of Stock A and B and the total return of the
portfolio.
Level of difficulty: Difficult
Solution:
R(A) = [(500)(30) - (500)(22)+(500)(2)(4)]/(500)(22)
= 73%
R(B) = [(1000)(30)-(1000)(30)+(1000)(1.5)(4)]/(1000)(30)
= 20%
wA = (500)(22)/[(500)(22)+(1000)(30)] = 0.2683
wB = (1000)(30)/[(500)(22)+(1000)(30)] = 0.7317
Total return of the portfolio = wAR(A)+wBR(B)
= 0.2683(73%)+0.7317(20%)
= 34.22%
38. In Problem 37, the ρAB is 0.3 and the standard deviations of Stock A and Stock B are 20
percent and 15 percent, respectively. Calculate the standard deviation of the portfolio.
20. Level of difficulty: Difficult
Solution:
p ( w A ) 2 ( A ) 2 ( wB ) 2 ( B ) 2 2( w A )( wB )( A, B )( A )( B )
(0.2683) 2 (20) 2 (0.7317) 2 (15) 2 2(0.2683)(0.7317)(0.3)(20)(15)
=
28.7940 120.4616 35.3367
= 184.5923
=13.59%
39. The Absent Minded Professors are exploring the risk of different portfolio allocations
between two stocks. Complete the following table.
Case 1 Case 2
Weight in Stock 1 35% 40%
Weight in Stock 2 65% 60%
Standard deviation of
3%
Stock 1
Standard deviation of
25% 20%
Stock 2
Covariance between .141685*.03*.25
.022
Stocks 1 and 2 = 0.001063
Correlation between .022/(.5162*.20)
Stocks 1 and 2 = 0.21308
Portfolio Variance .027 .0676
Portfolio Standard
16.4317% 26%
Deviation
ABC DEF
Expected return 3% 15%
Standard deviation 7% 35%
The correlation between ABC and DEF is 0.40. Calculate the expected return and standard
deviation of the portfolio2.
Level of difficulty: Difficult
Solution:
The total amount of cash the Profs have to provide is $1,000. When they short sell ABC they
will receive $200 and when added to their $1,000 they will have the $1,200 needed to buy
DEF. Consequently the weight in DEF is 1200/1000 = 1.2; the weight in ABC is —200/1000
= –20. The weight in ABC is negative because the market value of ABC is a liability.
41. The Absent Minded Professors are interested in two stocks: Alcon and Beldon. Both stocks
have an expected return of 8 percent. The standard deviation of Alcon is 3 percent and the
standard deviation of Beldon is 5 percent The Absent Minded Professors want the weights to
be greater than or equal to zero. What portfolio composition do you recommend to the
Absent Minded Professors if:
A. The correlation between the two stocks is -0.80
B. The correlation between the two stocks is 0.80.
Level of difficulty: Difficult
1
Short selling: Borrow the stock from the broker and sell it. In the future you will have to buy the stock and return it
to the broker.
2
Hint: The total invested is $1,000 and while individual weights can be greater than one or less than zero, the sum of
the weights must still be one.
Approaches:
1. Use calculus to minimize the variance of the portfolio by choice of weight.
42. The Absent Minded Professors are interested in two stocks: Alcon and Beldon. Both stocks
have a standard deviation of 8 percent. The expected return of Alcon is 10 percent and the
expected return of Beldon is 20 percent. The Absent Minded Professors want the weights to
be greater than or equal to zero. What portfolio composition do you recommend to the
Absent Minded Professors if:
A. The correlation is 0.00
B. The correlation is 1.0
Level of difficulty: Difficult
Solution:
A. The correlation is 0.00
The two companies have the same standard deviation and zero correlation so no matter what
weights we choose the portfolio variance will remain the same. Therefore, we will choose the
weights that maximize returns 100 percent in Beldon.
Therefore the portfolio I would recommend would maximize returns and would be 100%
invested in Beldon.
With any other correlations, there will be a tradeoff between risk and return and without
knowing the investors’ preferences we can’t recommend a portfolio weight.
43. The Absent Minded Professors wish to examine the effect of correlation on the efficient
frontier that can be created by investing in ABC and FGI. The expected return of ABC is 6%
with a standard deviation of 10%. The expected return of FGI is 10% with a standard
deviation of 25%. Graph the efficient frontier for:
A. A correlation of 0.00
B. A correlation of -0.50
C. A correlation of 0.50
Level of difficulty: Difficult
Solution:
Correlation:
0 0.5 -0.5
Weight in ABC Weight in FGIE(returns) Stdev0 Stdev-.5 Stdev.5
0 1 10.00% 25.00% 25.00% 25.00%
0.04 0.96 9.84% 24.00% 24.20% 23.80%
0.08 0.92 9.68% 23.01% 23.41% 22.61%
0.12 0.88 9.52% 22.03% 22.62% 21.43%
0.16 0.84 9.36% 21.06% 21.84% 20.25%
44 The Absent Minded Profs are interested in seeing the impact of diversification using observed
returns on real firms. Obtain monthly returns from January 2006 to December 2006 for the
following firms3:
Ticker Name
PFE.TO Pacific Energy Resources
3
Monthly historical prices, adjusted for dividends, are available from
http://ca.finance.yahoo.com . To obtain the data go to the website and type the ticker (don’t
forget the .TO) in the box labeled “Get Quotes”. When you get the page for the firm, on the left
hand side you will see a link to “historical prices”, click that and you will go to a page containing
the historical price data. Download the prices adjusted for dividends and splits. Do this for each
firm and then combine the data into one spreadsheet and to answer the question.
A. For the 15 firms, calculate the return on an equally weighted portfolio consisting of the
first firm, first and second, first and second and third ….. until you have a portfolio with
all 15 firms. Calculate the standard deviation of the monthly returns for each portfolio.
Plot the portfolio risk against the number of firms. As the number of firms increases,
what happens to the risk of the portfolio?
B. Compare your results using the real data with the artificial data used in Question 33. Do
you expect to be able to have a portfolio risk close to zero using real data? Explain your
reasoning.
C. Redo your analysis from part (a) with the stocks in a different order. Do you get the same
shape of graph? Explain how the shape could be different.
Level of difficulty: Difficult
Solution:
The data for four of the 15 firms:
The detailed calculations for the first three firms are presented below. Note: To calculate the
standard deviation of the portfolio, it is easier to just determine the returns of the portfolio each
month and then calculate the standard deviation. This is one of the advantages of Excel. Using
the portfolio variance formula would be more useful if we were investigating alternative
portfolio weights.
Also note how the returns are calculated. The data begins with the most recent so we need to be
careful to ensure that our calculation is the later stock adjusted stock price divided by the earlier.
Note: we cannot calculate a monthly return ending January 1, 2006 because the first price is only
observed for January 1. Remember, returns are (ending price + dividends)/beginning price.
I don’t expect to be able to remove all risk from the portfolio because these stocks are not
independent and there will be some covariance that I can’t remove (i.e., the market risk).
C.
If you change the order of the stocks, you will have a different shape to the graph. The
difference in the shape is due to the fact that you are dealing with a small sample of stocks
and random variation is to be expected.
45. The Absent Minded Profs want to examine a “real” efficient frontier involving Research in
Motion (RIM.TO) and the Royal Bank (RY.TO).
A. Using monthly data for these two companies from January 2006 to December 2006, graph
the relationship between risk and return.
B. Explain the difference between the frontier you developed in part (a) and the efficient
frontier.
C. Where do you expect the S&P/TSX index to plot relative to the frontier? Explain.
D. Download the S&P/TSX composite index data for the same period (ticker: ^GSPTSE) and
plot the S&P/TSX on your graph.
E. Based on your graph, is the S&P/TSX an efficient portfolio? Explain.
F. What do you expect to happen to the frontier if you increase the number of stocks?
Explain your reasoning.
Level of difficulty: Difficult
Solution:
A. Using monthly data for these two companies from January 2006 to December 2006, graph
the relationship between risk and return.
C. Where do you expect the S&P/TSX index to plot relative to the frontier? Explain.
I expect the S&P/TSXTSE index to plot above and to the left of the graph (i.e., it is an
efficient but unattainable portfolio with just RIM and the Royal Bank). The S&P/TSX index
contains most of the stocks on the market and I expect to find that increasing the number of
stocks in the portfolio will make me better off (i.e., higher returns and less risk) than holding
just two stocks.
D. Download the S&P/TSX composite index data for the same period (ticker: ^GSPTSE) and
plot the S&P/TSX on your graph.
The average monthly return of the S&P/TSX during this period was 0.74% with a
standard deviation of 2.81%. As expected the S&P/TSX will plot outside the RIM/RY
frontier.
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