Problem Set 2 - Solution - Fall 2023

For this problem set:

• CARA utility means a utility of the functional form:

u(w) ≡ − exp(−αw)

• CRRA utility means a utility of the functional form:

w1−α
u(w) ≡
1−α

• You will find data in a .csv file on Moodle pertaining to question 2 and 3. The 25 F-F portfolios and the
market portfolio are already expressed as excess returns. The risk-free rate is expressed as a monthly rate.
All values are expressed in percentage, i.e. 0.1 means 0.1% and not 10%

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

Question 1
Assume that returns are normally distributed and there is no labour income. Derive the CAPM assuming that
investors have CARA utility and show what the price of risk corresponds to.

Solution:

For an investor with CARA utility, her portfolio problem becomes:

α2 2
E[−exp(−αrp )] = −exp(−αµp + σ )
2 rp
α2 ′
= −α(R + (µ − R1)′ w) + w Σw
2
α2 ′
= α(R + (µ − R1)′ w) − w Σw
2

Maximizing this to obtain the optimal weights becomes:

α(µ − R1) − α2 Σw = 0
(µ − R1) − αΣw = 0
1
w = Σ−1 (µ − R1)
α

Also, an important observation is that this portfolio is proportional to the tangency portfolio:

w ∝ wT

Suppose we have I investors indexed by i = 1, ..., I and investor i’s risk aversion is α, then each investors optimal
portfolio becomes:

1 −1
wi = Σ (µ − R1)
αi

The optimal weight vector for the tangency portfolio is:

Σ−1 (µ − R1)
wT = ,
B − AR

where B − AR is the risk-aversion of the market, αm . Thus, we can rearrange to obtain:

wT αm = Σ−1 (µ − R1)

Substituting back into investor i’s optimal portfolio yields the individual demand:

1
wi = αm wT
αi

Next, we clear the market by aggregating the individual portfolios. First, we weight each portfolio by the
investor’s relative wealth:

Wi WI
PI ≡
i=1 Wi
W

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

Then, we aggregate and clear the market:

I I I
X Wi X Wi 1 X Wi αm
wi = αm wT = wT
i=1
W i=1
W αi i=1
W αi

Since αm ,W , and wT are constants, this can be rewritten as:

I I
X Wi αm X Wi
wi = wT
i=1
W W i=1 αi

Since the risk-less asset is in zero-net supply, the market-clearing condition requires that investors collectively
hold the tangency portfolio, or the market portfolio:

I
αm X Wi
wT = wm = wT
W i=1 αi

Note from before that:

Σ−1 (µ − R1) Σ−1 (µ − R1)

wT = =
B − AR αm

Thus:
I
Σ−1 (µ − R1) αm X Wi
wm =
αm W i=1 αi
I
1 X Wi
wm = Σ−1 (µ − R1)
W i=1 αi
I
!−1
1 X Wi
µ − R1 = Σwm
W i=1 αi

′
Pre-multiplying by wm yields:

I
!−1
′ 1 X Wi ′
wm (µ − R1) = wm Σwm
W i=1 αi
I
!−1
1 X Wi 2
µm − R = σm
W i=1 αi
I
!−1
µm − R 1 X Wi
2
=
σm W i=1 αi

Substituting back above yields:

µm − R
µ − R1 = 2
Σwm
σm

Thus, we obtain the standard CAPM expression for excess returns:

COV(r, rm )
µ − R1 = 2
(µm − R)
σm

since Σwm yields the covariances between all risky assets and the market return.

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

Question 2
In this exercise, you are asked to explore some empirical issues pertaining to the literature on stock market
returns. You can work with the same data set as in problem set one, i.e., the 25 Fama-French portfolios, the
market portfolio and the risk-free rate. You may use Excel to work on this question but feel free to use R or
MATLAB if you feel more comfortable with them to work on empirical problems.

a) Estimate the vector of sample mean excess returns and the covariance matrix of excess returns. Use these
estimates to compute two mean-variance efficient sets:

i) one for all portfolios not including the risk-free asset

ii) one for all portfolios including the risk-free asset

Plot the two efficient frontiers on a risk-return diagram and compute the Sharpe ratio of the tangency portfolio
and the market portfolio. Indicate in your plot where the market portfolio and the tangency portfolio lie in
the risk-return space.

b) Plot expected return against beta for each of the 25 Fama-French portfolios and compute the alpha of every
portfolio assuming the CAPM is the relevant pricing model. Comment on your results.

c) Test whether the market portfolio is far from the tangency portfolio by using the test statistic from Gibbons,
Ross, and Shanken. The GRS statsistic is equivalent to:

Sˆq2 − Sˆm
!
  2
T −N −1
∽ FN,T −N −1 ,
N 1 + Sˆ2
m

2
2 R̄M
where Sm is the squared Sharpe ratio of the market portfolio, 2
σR
(analogously for the tangency portfolio),
m
where R̄M denotes the expected excess return of the market, T denotes the number of time periods, and N
the number of portfolios. All returns are excess returns. The relevant critical values for the F-distribution
are 1.80, 1.52, and 1.39 for the 1%, 5%, and 10% significance level, respectively. Comment on your results.

Solutions: See Excel

Question 3
We now examine Black’s version of the CAPM discussed in class. Assume we have a continuum of investors
in [0, 1]. A fraction of investors, λ in [0, λ] can lend money but not borrow. The remaining investors in (λ, 1],
i.e.,1 − λ, have to hold a fraction 1 − m in cash.

a) Derive and provide an expression for ψ, the market wide tightness of the constraint, in the Black-CAPM
setting assuming equally wealthy investors.

Solution:

In Black’s CAPM, with the constraint the problem becomes:

αi ′
max R + (µ − R1)′ wi − w Σwi s.t. 1′ wi ≤ mi
wi 2 i

To solve this problem, we write the constrained problem as an unconstrained one using the Lagrangian:

ai ′
L = max R + (µ − R1)′ wi − w Σwi + ψi (mi − 1′ wi ),
wi 2 i

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

and the Karush-Kuhn-Tucker optimality conditions are:

∂L
= µ − R1 − ai Σwi − ψi 1 = 0
∂wi
∂L
= mi − 1′ wi = 0, ψi ≥ 0, ψi (mi − 1′ wi ) = 0
∂ψi

We can then rewrite the first KKT condition as:

ai Σwi = µ − (R + ψi )1
1
wi = Σ−1 (µ − (R + ψi )1)
αi

Next, just like before, we aggregate:

I I
X Wi X Wi 1 −1
wi = Σ (µ − (R + ψi )1)
i=1
W i=1
W αi
I I
X Wi 1 −1 X Wi 1 −1
= Σ (µ − R1) − Σ 1ψi
i=1
W αi i=1
W αi
I I
X Wi X W i ψi
= Σ−1 (µ − R1) − Σ−1 1
i=1
W αi i=1
W αi

Since it must hold that the sum of the weighted individual tightnesses must be equal to the market-wide
tightness,i.e., the tightness on average, we have that:

I I I
X Wi ψi X Wi ψ X Wi
= =ψ
i=1
W αi i=1
W αi i=1
W αi
I
!−1 I
X Wi X Wi ψi
ψ=
i=1
W αi i=1
W αi

Since the risk-less asset is in zero-net supply, the market-clearing condition requires that investors collectively
hold the tangency portfolio, or the market portfolio:

I I
X Wi X W i ψi
wm = Σ−1 (µ − R1) − Σ−1 1
i=1
W αi i=1
W αi
I
!−1 I
!−1 I
X Wi X Wi X Wi ψi
µ − R1 = Σwm + 1
i=1
W αi i=1
W αi i=1
W αi

Thus we have:

I
!−1
X Wi
µ − R1 = Σwm + ψ1
i=1
W αi

b) How do the slope and intercept of the CAPM change as λ increases and m decreases? Provide a formal
answer.

Solution:

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

We know that:

I
!−1
X Wi
µ − R1 = Σwm + ψ1
i=1
W αi

′
Pre-multiplying by wm yields:

I
!−1
X Wi ′ ′
µm − R = wm Σwm + ψwm 1
i=1
W αi
I
!−1
X Wi µm − R − ψ
= 2
i=1
W αi σm

Substituting back yields:

µm − R − ψ
µ − R1 = 2
Σwm + ψ1
σm
µm − R − ψ
µ − R1 = 2
COV(r, rm ) + ψ1
σm
µ − R1 = ψ1 + (µm − R − ψ)β

Therefore, we next examine how changes in λ and m affect ψ and thus the CAPM. ψ is defined as:

I
!−1 I
X Wi X W i ψi
ψ=
i=1
W αi i=1
W αi

Assuming equally wealthy constrained and unconstrained investor groups this can be written as:

ψ1 λψ1 α2 +(1−λ)ψ2 α1
1
2 (λ a1 + (1 − λ) ψa22 ) α1 α2 λψ1 α2 + (1 − λ)ψ2 α1
ψ= 1 1 = =
2 (λ a1 + (1 − λ) a12 ) λα2 +(1−λ)α1 λα2 + (1 − λ)α1
α1 α2

Next, we need an expression for ψi . Remember that the Karush-Kuhn-Tucker optimality conditions are:

∂L
= µ − R1 − ai Σwi − ψi 1 = 0
∂wi
∂L
= mi − 1′ wi = 0, ψi ≥ 0, ψi (mi − 1′ wi ) = 0
∂ψi

We can then rewrite the first KKT condition as:

ai Σwi = µ − (R + ψi )1
1
wi = Σ−1 (µ − (R + ψi )1)
αi

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

and then plug this expression into the second optimality condition to obtain:

1 ′ −1
mi = 1 Σ (µ − (R + ψi )1)
αi
mi αi = 1′ Σ−1 (µ − (R + ψi )1)
mi αi = 1′ Σ−1 µ − 1 Σ R1 − 1′ Σ−1 1ψ
′ −1
| {z } | {z } | {z }i
B RA ψi A
B − mi αi − RA
ψi =
A

We can plug the expression for ψi into the expression for ψ:

1 −RA
λ( B−αA )α2 + (1 − λ)( B−m2Aα2 −RA )α1
ψ=
λα2 + (1 − λ)α1

Note that the fraction λ is unconstrained, i.e., m = 1. If, for simplicity, we assume that all investors are
equally risk averse, we obtain:

λ( B−α−RA )α + (1 − λ)( B−m2Aα−RA )α

   
A B − α − RA B − m2 α − RA
ψ= =λ + (1 − λ)
λα + (1 − λ)α A A
B − RA − α(λ + (1 − λ)m)
=
A
αm − α(λ + (1 − λ)m)
=
A

Taking the FOCs yields:

∂ψ −α + mα
=
∂λ A
∂ψ −α(1 − λ)
=
∂m A

Thus, as m decreases, ψ increases, and when λ increases ψ decreases. Recalling that the SML

µ − R1 = ψ1 + (µm − R − ψ)β

represents the (cross-sectional) CAPM, we can conclude that If m decreases, the intercept increases and
the slope of the CAPM in the cross-section decreases. If λ increases, the intercept decreases and the slope
increases.

c) Why is this happening?

Solution:

The CAPM slope is reduced because constrained investors need high unleveraged returns. Therefore, they
are forced to invest in high-beta stocks with a higher expected return (but also with a lot more systemic
risk). This drives the demand for high beta stocks leading to a price appreciation ultimately lowering the
future expected return of high-beta stocks. Likewise, low-beta stocks drop in value due to little demand
increasing future expected return.

d) Compute the expression for the alpha of a strategy that holds a long position in low beta assets levered to
a beta of one, and holds short position in high beta stocks de-levered to one (i.e., the portfolio is market
neutral).

Solution:

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Investments HEC Finance
Fall 2023 Prof. Dr. Julien Cujean

The SML flattening suggests that we can bet against beta by going long low-beta stocks, leveraged to a beta
of one:

1
E[RL ] = E[RL − R]
βL

and go short high-beta stocks de-leveraged to a beta of one:

1
E[RH ] = E[RH − R]
βH

Substituting with the SML, this strategies expected return writes:

E[RBAB ] = E[RL ] − E[RH ]

1 1
= E[RL − R] − E[RH − R]
βL βH
1 1
= (ψ1 + (µm − R − ψ)βL ) − (ψ1 + (µm − R − ψ)βH )
βL βH
1 1 1 1
= ψ+ (µm − R − ψ)βL − ψ− (µm − R − ψ)βH
βL βL βH βH
1 1
= ψ− ψ
βL βH
 
1 1
= − ψ
βL βH

e) How large is this alpha if you apply the strategy to the 25 Fama-French portfolios in the data used in question
2?

Solution: See Excel

f) How tight should the restriction on cash, m, be to explain the alpha obtained in question d)?

Solution:

 
1 1
E[RBAB ] = − ψ
βL βH
E[RBAB ]
  =ψ
1 1
βL − βH

E[RBAB ] α − α(λ + (1 − λ)m)

 = m
1 1 A
βL − βH

E[RBAB ] α − αλ − αm + αλm
 = m
1 1 A
βL − βH

E[RBAB ]
A  − αm + αλ = m(λα − α)
1 1
βL − βH
 
1 E[R BAB ]
m= A   − αm + αλ
α(λ − 1) 1
− 1
βL βH