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Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Chapter 1: Problem 1
A. Opportunity Set
With one dollar, you can buy 500 red hots and no rock candies (point A),
or 100 rock candies and no red hots (point B), or any combination of red hots
and rock candies (any point along the opportunity set line AB).
Algebraically, if X = quantity of red hots and Y = quantity of rock candies,
then:
100 1 2 . 0 = + Y X
That is, the money spent on candies, where red hots sell for 0.2 cents a piece
and rock candy sells for 1 cent a piece, cannot exceed 100 cents ($1.00).
Solving the above equation for X gives:
Y X 5 500 ÷ =
which is the equation of a straight line, with an intercept of 500 and a slope of ÷5.
Elton, Gruber, Brown and Goetzmann 1
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
B. Indifference Map
Below is one indifference map. The indifference curves up and to the right
indicate greater happiness, since these curves indicate more consumption from
both candies. Each curve is negatively sloped, indicating a preference of more
to less, and each curve is convex, indicating that the rate of exchange of red
hots for rock candies decreases as more and more rock candies are consumed.
Note that the exact slopes of the indifference curves in the indifference map will
depend an the individual’s utility function and may differ among students.
Chapter 1: Problem 2
A. Opportunity Set
The individual can consume everything at time 2 and nothing at time 1,
which, assuming a riskless lending rate of 10%, gives the maximum time2
consumption amount:
$20 + $20 × (1 + 0.1) = $42.
Instead, the individual can consume everything at time 1 and nothing at
time 2, which, assuming a riskless borrowing rate of 10%, gives the maximum time
1 consumption amount:
$20 + $20 ÷ (1 + 0.1) = $38.18
Elton, Gruber, Brown and Goetzmann 2
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
The individual can also choose any consumption pattern along the line AB
(the opportunity set) below.
The opportunity set line can be determined as follows. Consumption at
time 2 is equal to the amount of money available in time 2, which is the income
earned at time 2, $20, plus the amount earned at time 2 from any money
invested at time 1, ($20 ÷ C1) × (1 + 0.1):
C2 = $20 + ($20 ÷ C1) × (1.1)
or
C2 = $42 ÷ 1.1C1
which is the equation of a straight line with an intercept of $42 and a slope of
÷1.1.
B. Indifference Map
We are given that the utility function of the individual is:
50
1 ) , (
2 1
2 1 2 1
C C
C C C C U + + + =
A particular indifference curve can be traced by setting U(C1,C2) equal to a
constant and then varying C1 and C2. By changing the constant, we can trace
out other indifference curves. For example, by setting U(C1,C2) equal to 50 we
get:
50
50
1
2 1
2 1
= + + +
C C
C C or 2450 50 50
2 1 2 1
= + + C C C C
Elton, Gruber, Brown and Goetzmann 3
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
This indifference curve appears in the graph of the indifference map below as
the curve labeled “50” (the lowest curve shown). By setting U(C1,C2) equal to 60,
we get the curve labeled “60,” etc.
C. Solution
The optimum solution is where the opportunity set is tangent to the highest
possible indifference curve (the point labeled “E” in the following graph).
This problem is meant to be solved graphically. Below, we show an analytical
solution:
50
1 ) , (
2 1
2 1 2 1
C C
C C C C U + + + =
Substituting the equation of the opportunity set given in part A for C2 in the
above equation gives:
50
1 . 1 42
1 . 1 42 1 ) , (
2
1 1
1 1 2 1
C C
C C C C U
÷
+ ÷ + + =
To maximize the utility function, we take the derivative of U with respect to C1
and set it equal to zero:
0
50
2 . 2
50
42
1 . 1 1
1
1
= ÷ + ÷ =
C
dC
dU
which gives C1 = $16.82. Substituting $16.82 for C1 in the equation of the
opportunity set given in part A gives C2 = $23.50.
Elton, Gruber, Brown and Goetzmann 4
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Chapter 1: Problem 3
If you consume nothing at time 1 and instead invest all of your time1
income at a riskless rate of 10%, then at time 2 you will be able to consume all of
your time2 income plus the proceeds earned from your investment:
$5,000 + $5,000 (1.1) = $10,500.
If you consume nothing at time 2 and instead borrow at time 1 the present value
of your time2 income at a riskless rate of 10%, then at time 1 you will be able to
consume all of the borrowed proceeds plus your time1 income:
$5,000 + $5,000 ÷ (1.1) = $9,545.45
All other possible optimal consumption patterns of time 1 and time 2
consumption appear on a straight line (the opportunity set) with an intercept of
$10,500 and a slope of ÷1.1:
C2 = $5,000 + ($5,000 ÷ C1) × (1.1) = $10,500 ÷ 1.1C1
Chapter 1: Problem 4
If you consume nothing at time 1 and instead invest all of your wealth plus your
time1 income at a riskless rate of 5%, then at time 2 you will be able to consume
all of your time2 income plus the proceeds earned from your investment:
$20,000 + ($20,000 + $50,000)(1.05) = $93,500.
Elton, Gruber, Brown and Goetzmann 5
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
If you consume nothing at time 2 and instead borrow at time 1 the present value
of your time2 income at a riskless rate of 5%, then at time 1 you will be able to
consume all of the borrowed proceeds plus your time1 income and your wealth:
$20,000 + $50,000 + $20,000 ÷ (1.05) = $89,047.62
All other possible optimal consumption patterns of time1 and time2
consumption appear on a straight line (the opportunity set) with an intercept of
$93,500 and a slope of ÷1.05:
C2 = $20,000 + ($20,000 + $50,000 ÷ C1) × (1.1)
= $93,500 ÷ 1.05C1
Chapter 1: Problem 5
With Job 1 you can consume $30 + $50 (1.05) = $82.50 at time 2 and
nothing at time 1, $50 + $30 ÷ (1.05) = $78.60 at time 1 and nothing at time 2, or
any consumption pattern of time 1 and time 2 consumption shown along the line
AB: C2 = $82.50 ÷ 1.05C1.
With Job 2 you can consume $40 + $40 (1.05) = $82.00 at time 2 and
nothing at time 1, $40 + $40 ÷ (1.05) = $78.10 at time 1 and nothing at time 2, or
any consumption pattern of time 1 and time 2 consumption shown along the line
CD: C2 = $82.00 ÷ 1.05C1.
The individual should select Job 1, since the opportunity set associated
with it (line AB) dominates the opportunity set of Job 2 (line CD).
Elton, Gruber, Brown and Goetzmann 6
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Chapter 1: Problem 6
With an interest rate of 10% and income at both time 1 and time 2 of
$5,000, the opportunity set is given by the line AB:
C2 = $5,000 + ($5,000 ÷ C1) × (1.1) = $10,500 ÷ 1.1C1
With an interest rate of 20% and income at both time 1 and time 2 of $5,000, the
opportunity set is given by the line CD:
C2 = $5,000 + ($5,000 ÷ C1) × (1.2) = $11,000 ÷ 1.2C1
Lines AB and CD intersect at point E (where C2 = time2 income = $5,000 and C1 =
time1 income = $5,000). Along either line above point E, the individual is lending
(consuming less at time 1 than the income earned at time 1); along either line
below point E, the individual is borrowing (consuming more at time 1 than the
income earned at time 1). Since the individual can only lend at 10% and must
borrow at 20%, the individual’s opportunity set is given by line segments AE and
ED.
Chapter 1: Problem 7
For P = 50, this is simply a plot of the function
1
1
2
1
50
C
C
C
+
÷
= .
For P = 100, this is simply a plot of the function
1
1
2
1
100
C
C
C
+
÷
= .
Elton, Gruber, Brown and Goetzmann 7
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Chapter 1: Problem 8
This problem is analogous to Problem 2. We present the analytical solution
below. The problem could be solved graphically, as in Problem 2.
From Problem 3, the opportunity set is C2 = $10,500 ÷ 1.1C1. Substituting this
equation into the preference function P = C1 + C2 + C1 C2 yields:
2
1 1 1 1
1 . 1 500 , 10 $ 1 . 1 500 , 10 $ C C C C P ÷ + ÷ + =
0 2 . 2 500 , 10 $ 1 . 1 1
1
1
= ÷ + ÷ = C
dC
dP
C1 = $4,772.68
C2 = $5,250.05
Chapter 1: Problem 9
Let X = the number of pizza slices, and let Y = the number of hamburgers.
Then, if pizza slices are $2 each, hamburgers are $2.50 each, and you have $10,
your opportunity set is given algebraically by
$2X + $2.50Y = $10
Solving the above equation for X gives X = 5 ÷ 1.25Y, which is the equation for a
straight line with an intercept of 5 and a slope of ÷1.25.
Graphically, the opportunity set appears as follows:
Assuming you like both pizza and hamburgers, your indifference curves will
be negatively sloped, and you will be better off on an indifference curve to the
right of another indifference curve. Assuming diminishing marginal rate of
substitution between pizza slices and hamburgers (the lower the number of
hamburgers you have, the more pizza slices you need to give up one more burger
without changing your level of satisfaction), your indifference curves will also be
convex.
Elton, Gruber, Brown and Goetzmann 8
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
A typical family of indifference curves appears below. Although you would rather
be on an indifference curve as far to the right as possible, you are constrained by
your $10 budget to be on an indifference curve that is on or to the left of the
opportunity set. Therefore, your optimal choice is the combination of pizza slices
and hamburgers that is represented by the point where your indifference curve is
just tangent to the opportunity set (point A below).
Chapter 1: Problem 10
If you consume C1 at time 1 and invest (lend) the rest of your time1 income at 5%,
your time2 consumption (C2) will be $50 from your time2 income plus ($50 ÷
C1)(1.05) from your investment. Algebraically, the opportunity set is thus
C2 = 50 + (50  C1)(1.05) = 102.50  1.05C1
If C1 is 0 (no time1 consumption), then from the above equation C2 will be $102.50.
If C2 is 0, then C1 will be $97.62. Graphically, the opportunity set appears below,
along with a typical family of indifference curves.
Elton, Gruber, Brown and Goetzmann 9
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Chapter 1: Problem 11
If you consume C1 at time 1 and invest (lend) the rest of your time1 income
at 20%, your time2 consumption (C2) will be $10,000 from your time2 income plus
$10,000 from your inheritance plus ($10,000  C1)(1.20) from your investment. The
opportunity set is thus
C2 = $10,000 + $10,000 + ($10,000  C1)(1.20) = $32,000  1.2C1
If C2 is 0 (no time2 consumption), then you can borrow the present value of your
time2 income and your time2 inheritance and spend that amount along with
your time1 income on time1 consumption. Solving the above equation for C1
when C2 is 0 gives C1 = $26,666.67, which is the maximum that can be consumed
at time 1. Similarly, if C1 is 0 (no time1 consumption), then you can invest all of your
time1 income at 20% and spend the future value of your time1 income plus your
time2 income and inheritance on time2 consumption. From the above equation,
C2 will be $32,000 when C1 is 0, which is the maximum that can be consumed at
time 2.
Chapter 1: Problem 12
If you consume nothing at time 2, then you can borrow the present value of
your time2 income for consumption at time 1. If the borrowing rate is 10% and
your time2 income is $100, then the present value (at time 1) of your time2
income is $100/(1.1) = $90.91. You can borrow this amount and spend it along with
your time income of $100 on time1 consumption. So the maximum you can
consume at time 1 is $90.91 + $100 = $190.91. If you consume nothing at time 1
and instead invest all of your time1 income of $100 at the lending rate of 5%, the
future value (in period 2) of your period 1 income will be $100(1.05) = $105. You
can then spend that amount along with your time 2 income of $100 on time2
consumption. So the maximum you can consume at time 2 is $105 + $100 = $205.
With two different interest rates, we have two separate equations for opportunity
sets: one for borrowers and one for lenders.
If you only consume some of your time 1 income at time 1 and invest the
rest at 5%, you have the following opportunity set: C2 = 100 + (100  C1)(1.05) = 205 
1.05C1. If you only consume some of your time2 income at time 2 and borrow the
present value of the rest at 10% for consumption at time 1, your opportunity set is:
C1 = 100 + (100  C2)/(1.1) = 190.91  C2/1.1,or, solving the equation for C2,
C2 = 210  1.1C1
Elton, Gruber, Brown and Goetzmann 10
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Graphically, the two lines appear as follows:
The lines intersect at point E (which represents your income endowment for times 1
and 2). Moving along the lines above point E represents lending (investing some
time1 income); moving along the lines below point E represents borrowing
(spending more than your time1 income on time1 consumption). Since you can
only lend at 5%, line segment AE represents your opportunity set if you choose to
lend. Since you must borrow at 10%, line segment ED represents your opportunity
set if you choose to borrow. So your total opportunity set is represented by AED.
Elton, Gruber, Brown and Goetzmann 11
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Elton, Gruber, Brown and Goetzmann 12
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 1
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 4
Chapter 4: Problem 1
A. Expected return is the sum of each outcome times its associated
probability.
Expected return of Asset 1 = =
1
R 16% × 0.25 + 12% × 0.5 + 8% × 0.25 = 12%
2
R = 6%;
3
R = 14%;
4
R = 12%
Standard deviation of return is the square root of the sum of the squares of
each outcome minus the mean times the associated probability.
Standard deviation of Asset 1 =
1
o = [(16% ÷ 12%)
2
× 0.25 + (12% ÷ 12%)
2
× 0.5 + (8% ÷ 12%)
2
× 0.25]
1/2
= 8
1/2
= 2.83%
2
o = 2
1/2
= 1.41%;
3
o = 18
1/2
= 4.24%;
4
o = 10.7
1/2
= 3.27%
B. Covariance of return between Assets 1 and 2 =
12
o =
(16 ÷ 12) × (4 ÷ 6) × 0.25 + (12 ÷ 12) × (6 ÷ 6) × 0.5 + (8 ÷ 12) × (8 ÷ 6) × 0.25
= ÷ 4
The variance/covariance matrix for all pairs of assets is:
1 2 3 4
1 8 ÷ 4 12 0
2 ÷ 4 2 ÷ 6 0
3 12 ÷ 6 18 0
4 0 0 0 10.7
Correlation of return between Assets 1 and 2 = 1
41 . 1 83 . 2
4
12
÷ =
×
÷
= µ .
The correlation matrix for all pairs of assets is:
1 2 3 4
1 1 ÷ 1 1 0
2 ÷ 1 1 ÷ 1 0
3 1 ÷ 1 1 0
4 0 0 0 1
Elton, Gruber, Brown and Goetzmann 13
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
C. Portfolio Expected Return
A 1/2 × 12% + 1/2 × 6% = 9%
B 13%
C 12%
D 10%
E 13%
F 1/3 × 12% + 1/3 × 6% + 1/3 × 14% = 10.67%
G 12.67%
H 12.67%
I 1/4 × 12% + 1/4 × 6% + 1/4 × 14% + 1/4 × 12% = 11%
Portfolio Variance
A (1/2)
2
× 8 + (1/2)
2
× 2 + 2 × 1/2 × 1/2 × (÷ 4) = 0.5
B 12.5
C 4.6
D 2
E 7
F (1/3)
2
× 8 + (1/3)
2
× 2 + (1/3)
2
× 18 + 2 × 1/3 × 1/3 × (÷ 4)
+ 2 × 1/3 × 1/3 × 12 + 2 × 1/3 × 1/3 × (÷ 6) = 3.6
G 2
H 6.7
I (1/4)
2
× 8 + (1/4)
2
× 2 + (1/4)
2
× 18 + (1/4)
2
× 10.7
+ 2 × 1/4 × 1/4 × (÷ 4) + 2 × 1/4 × 1/4 × 12 + 2 × 1/4
× 1/4 × 0 + 2 × 1/4 × 1/4 × (÷ 6) + 2 × 1/4 × 1/4 × 0 + 2 ×
1/4 × 1/4 × 0 = 2.7
Elton, Gruber, Brown and Goetzmann 14
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
Chapter 4: Problem 2
A. Monthly Returns
Month
Security 1 2 3 4 5 6
A 3.7% 0.4% 6.5% 1.4% 6.2% 2.1%
B 10.5% 0.5% 3.7% 1.0% 3.4% 1.4%
C 1.4% 14.9% 1.4% 10.8% 4.9% 16.9%
B. Sample Average (Mean) Monthly Returns
( )
% 22 . 1
6
% 1 . 2 % 2 . 6 % 4 . 1 % 5 . 6 % 4 . 0 % 7 . 3
=
+ + + ÷ +
=
A
R
% 95 . 2 =
B
R
% 92 . 7 =
C
R
C. Sample Standard Deviations of Monthly Returns
( ) ( ) ( ) ( ) ( ) ( )
% 92 . 3 34 . 15
6
% 22 . 1 % 1 . 2 % 22 . 1 % 2 . 6 % 22 . 1 % 4 . 1 % 22 . 1 % 5 . 6 % 22 . 1 % 4 . 0 % 22 . 1 % 7 . 3
2 2 2 2 2 2
= =
÷ + ÷ + ÷ + ÷ ÷ + ÷ + ÷
=
A
o
% 8 . 3 42 . 14 = =
B
o
% 78 . 6 02 . 46 = =
C
o
Elton, Gruber, Brown and Goetzmann 15
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
D. Sample Covariances and Correlation Coefficients of Monthly Returns
( ) ( ) ( ) ( ) ( ) ( )
( ) ( ) ( ) ( ) ( ) ( )
17 . 2
6
% 95 . 2 % 4 . 1 % 22 . 1 % 1 . 2 % 95 . 2 % 4 . 3 % 22 . 1 % 2 . 6 % 95 . 2 % 0 . 1 % 22 . 1 % 4 . 1
% 95 . 2 % 7 . 3 % 22 . 1 % 5 . 6 % 95 . 2 % 5 . 0 % 22 . 1 % 4 . 0 % 95 . 2 % 5 . 10 % 22 . 1 % 7 . 3
=
(
¸
(
¸
÷ ÷ × ÷ + ÷ × ÷ + ÷ × ÷ +
÷ × ÷ ÷ + ÷ × ÷ + ÷ × ÷
=
AB
o
24 . 7 =
AC
o ; 89 . 19 ÷ =
BC
o
15 . 0
8 . 3 92 . 3
17 . 2
=
×
=
AB
µ
27 . 0 =
AC
µ ; 77 . 0 ÷ =
BC
µ
E. Portfolio Returns and Standard Deviations
Portfolio 1 (X1 = 1/2; X2= 1/2; X3= 0):
% 09 . 2 % 92 . 7 0 % 95 . 2 2 / 1 % 22 . 1 2 / 1 1 = × + × + × = P R
( ) ( ) ( )
% 92 . 2 53 . 8
89 . 19 0 2 / 1 24 . 7 0 2 / 1 17 . 2 2 / 1 2 / 1 2 02 . 46 0 42 . 14 2 / 1 34 . 15 2 / 1
2 2 2
1
= =
× × + × × + × × × + × + × + × =
P
o
Portfolio 2 (X1 = 1/2; X2= 0; X3= 1/2):
% 57 . 4 2 = P R
% 35 . 4 96 . 18
2
= =
P
o
Portfolio 3 (X1 = 0; X2= 1/2; X3= 1/2):
% 44 . 5
3
=
P
R
% 27 . 2 17 . 5
3
= =
P
o
Portfolio 4 (X1 = 1/3; X2= 1/3; X3= 1/3):
% 03 . 4 4 = P R
% 47 . 2 09 . 6
4
= =
P
o
Elton, Gruber, Brown and Goetzmann 16
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
Chapter 4: Problem 3
It is shown in the text below Table 4.8 that a formula for the variance of an
equally weighted portfolio (where Xi = 1/N for i = 1, …, N securities) is
( )
o o o o kj kj
2
j
2
P
1/N = + ÷
where
o
2
j
is the average variance across all securities,
o kj
is the average
covariance across all pairs of securities, and N is the number of securities. Using the
above formula with
o
2
j
= 50 and
o kj
= 10 we have:
Portfolio Size (N)
o
2
P
5 18
10 14
20 12
50 10.8
100 10.4
Chapter 4: Problem 4
As is shown in the text, as the number of securities (N) approaches infinity, an
equally weighted portfolio’s variance (total risk) approaches a minimum equal
to the average covariance of the pairs of securities in the portfolio, which in
Problem 3 is given as 10. Therefore, 10% above the minimum risk level would result
in the portfolio’s variance being equal to 11. Setting the formula shown in the
above answer to Problem 3 equal to 11 and using
o
2
j
= 50 and
okj
= 10 we have:
( ) 11 10 10 50 / 1
2
= + ÷ × = N
P
o
Solving the above equation for N gives N = 40 securities.
Elton, Gruber, Brown and Goetzmann 17
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
Chapter 4: Problem 5
As shown in the text, if the portfolio contains only one security, then the portfolio’s
average variance is equal to the average variance across all securities,
o
2
j
. If
instead an equally weighted portfolio contains a very large number of securities,
then its variance will be approximately equal to the average covariance of the
pairs of securities in the portfolio,
o kj
. Therefore, the fraction of risk that of an
individual security that can be eliminated by holding a large portfolio is expressed
by the following ratio:
2
2
i
kj i
o
o o ÷
From Table 4.9, the above ratio is equal to 0.6 (60%) for Italian securities and 0.8
(80%) for Belgian securities. Setting the above ratio equal to those values and
solving for
okj
gives
2
4 . 0
i kj
o o = for Italian securities and
2
2 . 0
i kj
o o = for Belgian
securities.
Thus, the ratio
kj
kj i
o
o o ÷
2
equals 5 . 1
4 . 0
4 . 0
2
2 2
=
÷
i
i i
o
o o
for Italian securities and
4
2 . 0
2 . 0
2
2 2
=
÷
i
i i
o
o o
for Belgian securities.
If the average variance of a single security,
o
2
j
, in each country equals 50, then
20 50 4 . 0 4 . 0
2
= × = =
i kj
o o for Italian securities and 10 50 2 . 0 2 . 0
2
= × = =
i kj
o o for
Belgian securities.
Using the formula shown in the preceding answer to Problem 3 with
o
2
j
= 50 and
either
okj
= 20 for Italy or
okj
= 10 for Belgium we have:
Portfolio Size (N securities) Italian Belgian
o
2
P o
2
P
5 26 18
20 21.5 12
100 20.3 10.4
Elton, Gruber, Brown and Goetzmann 18
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
Chapter 4: Problem 6
The formula for an equally weighted portfolio's variance that appears below Table
4.8 in the text is
( )
o o o o kj kj
2
j
2
P
1/N = + ÷
where
o
2
j
is the average variance across all securities,
okj
is the average
covariance across all securities, and N is the number of securities. The text below
Table 4.8 states that the average variance for the securities in that table was
46.619 and that the average covariance was 7.058. Using the above equation
with those two numbers, setting equal to 8, and solving for N gives:
o
2
P
8 = 1/N (46.619  7.058) + 7.058
.942N = 39.561
N = 41.997.
Since the portfolio's variance decreases as N increases, holding 42 securities will
provide a variance less than 8, so 42 is the minimum number of securities that will
provide a portfolio variance less than 8.
Elton, Gruber, Brown and Goetzmann 19
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
Elton, Gruber, Brown and Goetzmann 20
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 4
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 5
Chapter 5: Problem 1
From Problem 1 of Chapter 4, we know that:
R1 = 12% R2 = 6% R3 = 14% R4 = 12%
o
2
1 = 8 o
2
2 = 2 o
2
3 = 18 o
2
4 = 10.7
o 1 = 2.83% o 2 = 1.41% o 3 = 4.24% o 4 = 3.27%
o 12 = ÷ 4 o 13 = 12 o 14 = 0 o 23 = ÷ 6 o 24 = 0 o 34 = 0
µ 12 = ÷ 1 µ 13 = 1 µ 14 = 0 µ 23 = ÷ 1.0 µ 24 = 0 µ 34 = 0
In this problem, we will examine 2asset portfolios consisting of the following pairs
of securities:
Pair Securities
A 1 and 2
B 1 and 3
C 1 and 4
D 2 and 3
E 2 and 4
F 3 and 4
A. Short Selling Not Allowed
(Note that the answers to part A.4 are integrated with the answers to parts A.1,
A.2 and A.3 below.)
A.1
We want to find the weights, the standard deviation and the expected return of
the minimumrisk porfolio, also known as the global minimum variance (GMV)
portfolio, of a pair of assets when short sales are not allowed.
Elton, Gruber, Brown and Goetzmann 21
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
We further know that the compostion of the GMV portfolio of any two assets i
and j is:
ij j i
ij j
GMV
i
X
o o o
o o
2
2 2
2
÷ +
÷
=
GMV
i
GMV
j
X X ÷ = 1
Pair A (assets 1 and 2):
Applying the above GMV weight formula to Pair A yields the following weights:
3
1
18
6
) 4 )( 2 ( 2 8
) 4 ( 2
2
12
2
2
2
1
12
2
2
1
= =
÷ ÷ +
÷ ÷
=
÷ +
÷
=
o o o
o o
GMV
X (or 33.33%)
3
2
3
1
1 1
1 2
= ÷ = ÷ =
GMV GMV
X X (or 66.67%)
This in turn gives the following for the GMV portfolio of Pair A:
% 8 % 6
3
2
% 12
3
1
= × + × = GMV R
( ) ( ) ( ) ( ) 0 4
3
2
3
1
2 2
3
2
8
3
1
2 2
2
= ÷ 
.

\


.

\

+ 
.

\

+ 
.

\

=
GMV
o
0 =
GMV
o
Recalling that µ 12 = ÷ 1, the above result demonstrates the fact that, when two
assets are perfectly negatively correlated, the minimumrisk portfolio of those two
assets will have zero risk.
Pair B (assets 1 and 3):
Applying the above GMV weight formula to Pair B yields the following weights:
3
1
=
GMV
X (300%) and (÷200%) 2
3
÷ =
GMV
X
This means that the GMV portfolio of assets 1 and 3 involves short selling asset 3.
But if short sales are not allowed, as is the case in this part of Problem 1, then the
GMV “portfolio” involves placing all of your funds in the lower risk security (asset 1)
and none in the higher risk security (asset 3). This is obvious since, because the
correlation between assets 1 and 3 is +1.0, portfolio risk is simply a linear
combination of the risks of the two assets, and the lowest value that can be
obtained is the risk of asset 1.
Elton, Gruber, Brown and Goetzmann 22
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Thus, when short sales are not allowed, we have for Pair B:
1
1
=
GMV
X (100%) and (0%) 0
3
=
GMV
X
% 12 1 = = R RGMV ; ; 8
2
1
2
= = o o
GMV
% 83 . 2
1
= = o o
GMV
For the GMV portfolios of the remaining pairs above we have:
Pair
GMV
i
X
GMV
j
X GMV R
GMV
o
C (i = 1, j = 4) 0.572 0.428 12% 2.14%
D (i = 2, j = 3) 0.75 0.25 8% 0%
E (i = 2, j = 4) 0.8425 0.1575 6.95% 1.3%
F (i = 3, j = 4) 0.3728 0.6272 12.75% 2.59%
A.2 and A.3
For each of the above pairs of securities, the graph of all possible combinations
(portfolios) of the securities (the portfolio possibilties curves) and the efficient set
of those portfolios appear as follows when short sales are not allowed:
Pair A
The efficient set is the positively sloped line segment.
Elton, Gruber, Brown and Goetzmann 23
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair B
The entire line is the efficient set.
Pair C
Only the GMV portfolio is efficient.
Elton, Gruber, Brown and Goetzmann 24
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair D
The efficient set is the positively sloped line segment.
Pair E
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security 4.
Elton, Gruber, Brown and Goetzmann 25
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair F
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security 3.
B. Short Selling Not Allowed
(Note that the answers to part B.4 are integrated with the answers to parts B.1,
B.2 and B.3 below.)
B.1
When short selling is allowed, all of the GMV portfolios shown in Part A.1 above
are the same except the one for Pair B (assets 1 and 3). In the noshortsales case
in Part A.1, the GMV “portfolio” for Pair B was the lower risk asset 1 alone.
However, applying the GMV weight formula to Pair B yielded the following
weights:
3
1
=
GMV
X (300%) and (÷200%) 2
3
÷ =
GMV
X
This means that the GMV portfolio of assets 1 and 3 involves short selling asset 3 in
an amount equal to twice the investor’s original wealth and then placing the
original wealth plus the proceeds from the short sale into asset 1. This yields the
following for Pair B when short sales are allowed:
% 8 % 14 2 % 12 3 = × ÷ × = GMV R
( ) ( ) ( ) ( ) ( )( )( )( ) 0 12 2 3 2 18 2 8 3
2 2
2
= ÷ + ÷ + =
GMV
o
0 =
GMV
o
Recalling that µ 13 = +1, this demonstrates the fact that, when two assets are
perfectly positively correlated and short sales are allowed, the GMV portfolio of
those two assets will have zero risk.
Elton, Gruber, Brown and Goetzmann 26
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
B.2 and B.3
When short selling is allowed, the portfolio possibilities graphs are extended.
Pair A
The efficient set is the positively sloped line segment through security 1 and out
toward infinity.
Pair B
The entire line out toward infinity is the efficient set.
Elton, Gruber, Brown and Goetzmann 27
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair C
Only the GMV portfolio is efficient.
Pair D
The efficient set is the positively sloped line segment through security 3 and out
toward infinity.
Elton, Gruber, Brown and Goetzmann 28
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair E
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security 4 toward infinity.
Pair F
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security 3 toward infinity.
Elton, Gruber, Brown and Goetzmann 29
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
C.
Pair A (assets 1 and 2):
Since the GMV portfolio of assets 1 and 2 has an expected return of 8% and a risk
of 0%, then, if riskless borrowing and lending at 5% existed, one would borrow an
infinite amount of money at 5% and place it in the GMV portfolio. This would be
pure arbitrage (zero risk, zero net investment and positive return of 3%). With an
8% riskless lending and borrowing rate, one would hold the same portfolio one
would hold without riskless lending and borrowing. (The particular portfolio held
would be on the efficient frontier and would depend on the investor’s degree of
risk aversion.)
Pair B (assets 1 and 3):
Since short sales are allowed in Part C and since we saw in Part B that when short
sales are allowed the GMV portfolio of assets 1 and 3 has an expected return of
8% and a risk of 0%, the answer is the same as that above for Pair A.
Pair C (assets 1 and 4):
We have seen that, regardless of the availability of short sales, the efficient
frontier for this pair of assets was a single point representing the GMV portfolio,
with a return of 12%. With riskless lending and borrowing at either 5% or 8%, the
new efficient frontier (efficient set) will be a straight line extending from the
vertical axis at the riskless rate and through the GMV portfolio and out to infinity.
The amount that is invested in the GMV portfolio and the amount that is
borrowed or lent will depend on the investor’s degree of risk aversion.
Pair D (assets 2 and 3):
Since assets 2 and 3 are perfectly negatively correlated and have a GMV
portfolio with an expected return of 8% and a risk of 0%, the answer is identical to
that above for Pair A.
Pair E (assets 2 and 4):
We arrived at the following answer graphically; the analytical solution to this
problem is presented in the subsequent chapter (Chapter 6). With a riskless rate
of 5%, the new efficient frontier (efficient set) will be a straight line extending from
the vertical axis at the riskless rate, passing through the portfolio where the line is
tangent to the upper half of the original portfolio possibilities curve, and then out
to infinity. The amount that is invested in the tangent portfolio and the amount
that is borrowed or lent will depend on the investor’s degree of risk aversion. The
tangent portfolio has an expected return of 9.4% and a standard deviation of
1.95%. With a riskless rate of 8%, the point of tangency occurs at infinity.
Elton, Gruber, Brown and Goetzmann 30
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair F (assets 3 and 4):
We arrived at the following answer graphically; the analytical solution to this
problem is presented in the subsequent chapter (Chapter 6). With a riskless rate
of 5%, the new efficient frontier (efficient set) will be a straight line extending from
the vertical axis at the riskless rate, passing through the portfolio where the line is
tangent to the upper half of the original portfolio possibilities curve, and then out
to infinity. The amount that is invested in the tangent portfolio and the amount
that is borrowed or lent will depend on the investor’s degree of risk aversion. The
tangent (optimal) portfolio has an expected return of 12.87% and a standard
deviation of 2.61%. With a riskless rate of 8%, the new efficient frontier will be a
straight line extending from the vertical axis at the riskless rate, passing through
the portfolio where the line is tangent to the upper half of the original portfolio
possibilities curve, and then out to infinity. The tangent (optimal) portfolio has an
expected return of 12.94% and a standard deviation of 2.64%.
Chapter 5: Problem 2
From Problem 2 of Chapter 4, we know that:
RA = 1.22% RB = 2.95% RC = 7.92%
o
2
A = 15.34 o
2
B = 14.42 o
2
C = 46.02
o A = 3.92% o B = 3.8% o C = 6.78%
o AB = 2.17 o AC = 7.24 o BC = ÷19.89
µ AB = 0.15 µ AC = 0.27 µ BC = ÷0.77
In this problem, we will examine 2asset portfolios consisting of the following pairs
of securities:
Pair Securities
1 A and B
2 A and C
3 B and C
Elton, Gruber, Brown and Goetzmann 31
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
A. Short Selling Not Allowed
(Note that the answers to part A.4 are integrated with the answers to parts A.1,
A.2 and A.3 below.)
A.1
We want to find the weights, the standard deviation and the expected return of
the minimumrisk porfolio, also known as the global minimum variance (GMV)
portfolio, of a pair of assets when short sales are not allowed.
We further know that the compostion of the GMV portfolio of any two assets i
and j is:
ij j i
ij j
GMV
i
X
o o o
o o
2
2 2
2
÷ +
÷
=
GMV
i
GMV
j
X X ÷ = 1
Pair 1 (assets A and B):
Applying the above GMV weight formula to Pair 1 yields the following weights:
482 . 0
) 17 . 2 )( 2 ( 42 . 14 34 . 15
17 . 2 42 . 14
2
2 2
2
=
÷ +
÷
=
÷ +
÷
=
AB B A
AB B GMV
A
X
o o o
o o
(or 48.2%)
518 . 0 482 . 0 1 1 = ÷ = ÷ =
GMV
A
GMV
B
X X (or 51.8%)
This in turn gives the following for the GMV portfolio of Pair 1:
% 12 . 2 % 95 . 2 518 . 0 % 22 . 1 482 . 0 = × + × = GMV R
( ) ( ) ( ) ( ) ( )( )( )( ) 52 . 8 17 . 2 518 . 0 482 . 0 2 42 . 14 518 . 0 34 . 15 482 . 0
2 2 2
= + + =
GMV
o
% 92 . 2 =
GMV
o
Elton, Gruber, Brown and Goetzmann 32
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
For the GMV portfolios of the remaining pairs above we have:
Pair
GMV
i
X
GMV
j
X GMV R
GMV
o
2 (i = A, j = C) 0.827 0.173 2.38% 3.73%
3 (i = B, j = C) 0.658 0.342 4.65% 1.63%
A.2 and A.3
For each of the above pairs of securities, the graph of all possible combinations
(portfolios) of the securities (the portfolio possibilties curves) and the efficient set
of those portfolios appear as follows when short sales are not allowed:
Pair 1
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security B.
Elton, Gruber, Brown and Goetzmann 33
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair 2
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security C.
Pair 3
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and ending at security C.
Elton, Gruber, Brown and Goetzmann 34
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
B. Short Selling Not Allowed
(Note that the answers to part B.4 are integrated with the answers to parts B.1,
B.2 and B.3 below.)
B.1
When short selling is allowed, all of the GMV portfolios shown in Part A.1 above
remain the same.
B.2 and B.3
When short selling is allowed, the portfolio possibilities graphs are extended.
Pair 1
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security B toward infinity.
Elton, Gruber, Brown and Goetzmann 35
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Pair 2
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security C toward infinity.
Pair 3
The efficient set is the positively sloped part of the curve, starting at the GMV
portfolio and extending past security C toward infinity.
Elton, Gruber, Brown and Goetzmann 36
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
C.
In all cases where the riskless rate of either 5% or 8% is higher than the returns on
both of the individual securities, if short sales are not allowed, any rational
investor would only invest in the riskless asset. Even if short selling is allowed, the
point of tangency of a line connecting the riskless asset to the original portfolio
possibilities curve occurs at infinity for all cases, since the original GMV portfolio’s
return is lower than 5% in all cases.
Chapter 5: Problem 3
The answers to this problem are given in the answers to part A.1 of Problem 2.
Chapter 5: Problem 4
The locations, in expected return standard deviation space, of all portfolios
composed entirely of two securities that are perfectly negatively correlated (say,
security C and security S) are described by the equations for two straight lines, one
with a positive slope and one with a negative slope. To derive those equations,
start with the expressions for a twoasset portfolio's standard deviation when the
two assets' correlation is ÷1 (the equations in (5.8) in the text), and solve for XC (the
investment weight for security C). E.g., for the first equation:
( )
.
+
+
=
X
) + (
X
= +
X
+ 
X
=
X X
=
S C
S P
C
S C C S P
S C S C C P
S C C C P
o o
o o
o o o o
o o o o
o o o
÷ ÷ 1
Now plug the above expression for XC into the expression for a twoasset portfolio's
expected return and simplify:
( )
.
+
R R
+
R R
+
R
=
+
R R R
+
R
+
R
=
R
+
+
+
R
+
+
=
R X
+
R X
=
R
P
S C
S C
S
S C
S C
S
S C
S S S P C S C P
S
S
S C
S P
C
S C
S P
S C C C P
o
o o
o
o o
o o
o o o o
o o
o o
o o
o o
(
(
¸
(
¸
÷
+
(
(
¸
(
¸
÷
÷ ÷


.

\

÷


.

\

÷
1
1
The above equation is that of a straight line in expected return standard deviation
space, with an intercept equal to the first term in brackets and a slope equal to
the second term in brackets.
Elton, Gruber, Brown and Goetzmann 37
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Solving for XC in the second equation in (5.8) gives:
( )
( )
.
+
=
X
+
X
=
X
+
X
=
X
+
X
=
S C
P S
C
S C C S P
S C S C C P
S C C C P
o o
o o
o o o o
o o o o
o o o
÷
÷ ÷
÷ ÷
÷ ÷ 1
Substitute the above expression for XC into the equation for expected return and
simplify:
( )
.
+
R R
+
R R
+
R
=
+
R
+
R R R
+
R
=
R
+
+
R
+
=
R X
+
R X
=
R
P
S C
C S
S
S C
S C
S
S C
S P S S C P C S
S
S
S C
P S
C
S C
P S
S C C C P
o
o o
o
o o
o o
o o o o
o o
o o
o o
o o
(
(
¸
(
¸
÷
+
(
(
¸
(
¸
÷
÷ ÷


.

\
 ÷
÷


.

\
 ÷
÷
1
1
The above equation is also that of a straight line in expected return standard
deviation space, with an intercept equal to the first term in brackets and a slope
equal to the second term in brackets. The intercept term for the above equation is
identical to the intercept term for the first derived equation. The slope term is
equal to ÷1 times the slope term of the first derived equation. So when one
equation has a positive slope, the other equation has a negative slope (when the
expected returns of the two assets are equal, the two lines are coincident), and
both lines meet at the same intercept.
Chapter 5: Problem 5
When ǒ equals 1, the least risky "combination" of securities 1 and 2 is security 2 held
alone (assuming no short sales). This requires X1 = 0 and X2 = 1, where the X's are
the investment weights. The standard deviation of this "combination" is equal to
the standard deviation of security 2; ǔP = ǔ2 = 2.
When ǒ equals 1, we saw in Chapter 5 that we can always find a combination of
the two securities that will completely eliminate risk, and we saw that this
combination can be found by solving X1 = ǔ2/(ǔ1 + ǔ2). So, X1 = 2/(5 + 2) = 2/7, and
since the investment weights must sum to 1, X2 = 1  X1 = 1  2/7 = 5/7. So a
combination of 2/7 invested in security 1 and 5/7 invested in security 2 will
completely eliminate risk when ǒ equals 1, and ǔP will equal 0.
Elton, Gruber, Brown and Goetzmann 38
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
When ǒ equals 0, we saw in Chapter 5 that the minimumrisk combination of two
assets can be found by solving X1 = ǔ2
2
/(ǔ1
2
+ ǔ2
2
). So, X1 = 4/(25 + 4) = 4/29, and X2
= 1  X1 = 1  4/29 = 25/29. When ǒ equals 0, the expression for the standard
deviation of a twoasset portfolio is
( )
2
2
2
1
2
1
2
1
1 o o
o
X X =
P
÷ +
Substituting 4/29 for X1 in the above equation, we have
% 86 . 1
841
2900
841
2500
841
400
4
29
25
25
29
4
2 2
=
=
+ =
× 
.

\

+ × 
.

\

=
P
o
Chapter 5: Problem 6
If the riskless rate is 10%, then the riskfree asset dominates both risky assets in terms
of risk and return, since it offers as much or higher expected return than either risky
asset does, for zero risk. Assuming the investor prefers more to less and is risk averse,
the optimal investment is the riskfree asset.
Elton, Gruber, Brown and Goetzmann 39
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Elton, Gruber, Brown and Goetzmann 40
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 5
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 6
Chapter 6: Problem 1
The simultaneous equations necessary to solve this problem are:
5 = 16Z1 + 20Z2 + 40Z3
7 = 20Z1 + 100Z2 + 70Z3
13 = 40Z1 + 70Z2 + 196Z3
The solution to the above set of equations is:
Z1 = 0.292831
Z2 = 0.009118
Z3 = 0.003309
This results in the following set of weights for the optimum (tangent) portfolio:
X1 = .95929 (95.929%)
X2 = .02987 (2.987%)
X3 = .01084 (1.084%
The optimum portfolio has a mean return of 10.146% and a standard deviation of
4.106%.
Chapter 6: Problem 2
The simultaneous equations necessary to solve this problem are:
11 ÷ RF = 4Z1 + 10Z2 + 4Z3
14 ÷ RF = 10Z1 + 36Z2 + 30Z3
17 ÷ RF = 4Z1 + 30Z2 + 81Z3
Elton, Gruber, Brown and Goetzmann 41
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 6
The optimum portfolio solutions using Lintner short sales and the given values for RF
are:
RF = 6% RF = 8% RF = 10%
Z1 3.510067 1.852348 0.194631
Z2 ÷1.043624 ÷0.526845 ÷0.010070
Z3 0.348993 0.214765 0.080537
X1 0.715950 0.714100 0.682350
X2 ÷0.212870 ÷0.203100 ÷0.035290
X3 0.711800 0.082790 0.282350
Tangent (Optimum) Portfolio
Mean Return 6.105% 6.419% 11.812%
Tangent (Optimum) Portfolio
Standard Deviation 0.737% 0.802% 2.971%
Chapter 6: Problem 3
Since short sales are not allowed, this problem must be solved as a quadratic
programming problem. The formulation of the problem is:
P
F
P
X
R R
o
u
÷
= max
subject to:
1
1
=
_
=
N
i
i
X
0 >
i
X ¬ i
Elton, Gruber, Brown and Goetzmann 42
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 6
Chapter 6: Problem 4
This problem is most easily solved using The Investment Portfolio software that
comes with the text, but, since all pairs of assets are assumed to have the same
correlation coefficient of 0.5, the problem can also be solved manually using the
constant correlation form of the Elton, Gruber and Padberg “Simple Techniques”
described in a later chapter.
To use the software, open up the Markowitz module, select “file” then “new” then
“group constant correlation” to open up a constant correlation table. Enter the
input data into the appropriate cells by first double clicking on the cell to make it
active. Once the input data have been entered, click on “optimizer” and then
“run optimizer” (or simply click on the optimizer icon). At that point, you can either
select “full Markowitz” or “simple method.”
If you select “full Markowitz,” you then select “short sales allowed/riskless lending
and borrowing” and then enter 4 for both the lending and borrowing rate and
click “OK.” A graph of the efficient frontier then appears. You may then hit the
“Tab” key to jump to the tangent portfolio, then click on “optimizer” and then
“show portfolio” (or simply click on the “show portfolio” icon) to view and print the
composition (investment weights), mean return and standard deviation of the
tangent (optimum) portfolio.
If instead you select “simple method,” you then select “short sales allowed with
riskless asset” and enter 4 for the riskless rate and click “OK.” A table showing the
investment weights of the tangent portfolio then appears.
Regardless of the method used, the resulting investment weights for the optimum
portfolio are as follows:
Asset i Xi
1 ÷5.999%
2 ÷17.966%
3 21.676%
4 0.478%
5 ÷29.585%
6 12.693%
7 ÷59.170%
8 ÷14.793%
9 3.442%
10 189.224%
Elton, Gruber, Brown and Goetzmann 43
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 6
Given the above weights, the optimum (tangent) portfolio has a mean return of
18.907% and a standard deviation of 3.297%. The efficient frontier is a positively
sloped straight line starting at the riskless rate of 4% and extending through the
tangent portfolio (T) and out to infinity:
Chapter 6: Problem 5
Since the given portfolios, A and B, are on the efficient frontier, the GMV portfolio
can be obtained by finding the minimumrisk combination of the two portfolios:
3
1
20 2 16 36
20 16
2
2 2
2
÷ =
× ÷ +
÷
=
÷ +
÷
=
AB B A
AB B GMV
A
X
o o o
o o
3
1
1 1 = ÷ =
GMV
A
GMV
B
X X
This gives % 33 . 7 = GMV R and % 83 . 3 =
GMV
o
Also, since the two portfolios are on the efficient frontier, the entire efficient frontier
can then be traced by using various combinations of the two portfolios, starting
with the GMV portfolio and moving up along the efficient frontier (increasing the
weight in portfolio A and decreasing the weight in portfolio B). Since XB = 1 ÷ XA
the efficient frontier equations are:
( ) ( )
A A B A A A P
X X R X R X R ÷ × + = ÷ + = 1 8 10 1
( ) ( )
( ) ( )
A A A A
AB A A B A A A P
X X X X
X X X X
÷ + ÷ + =
÷ + ÷ + =
1 40 1 16 36
1 2 1
2 2
2 2 2 2
o o o o
Elton, Gruber, Brown and Goetzmann 44
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 6
Since short sales are allowed, the efficient frontier will extend beyond portfolio A
and out toward infinity. The efficient frontier appears as follows:
Elton, Gruber, Brown and Goetzmann 45
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 6
Elton, Gruber, Brown and Goetzmann 46
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 6
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 7
Chapter 7: Problem 1
We will illustrate the answers for stock A and the market portfolio (S&P 500); the
answers for stocks B and C are found in an identical manner.
The sample mean monthly return on stock A is:
% 946 . 2
12
94 . 0 48 . 7 75 . 12 07 . 1 18 . 1 97 . 8 79 . 2 16 . 3 57 . 1 12 . 4 27 . 15 05 . 12
12
12
1
=
÷ + + + ÷ ÷ ÷ + + ÷ +
=
=
_
= t
At
A
R
R
The sample mean monthly return on the market portfolio (the answer to part 1.E) is:
% 005 . 3
12
15 . 1 47 . 2 16 . 6 46 . 3 11 . 2 77 . 6 43 . 4 41 . 4 48 . 4 41 . 2 99 . 5 28 . 12
12
12
1
=
÷ + + + ÷ ÷ + + + + +
=
=
_
= t
mt
m
R
R
Using data given in the problem and the above two sample mean monthly returns,
we have the following:
Month t
A At
R R ÷ ( )
2
A At
R R ÷
m mt
R R ÷ ( )
2
m mt
R R ÷ ( )( )
m mt A At
R R R R ÷ ÷
1 9.104 82.883 9.275 86.026 84.44
2 12.324 151.881 2.985 8.910 36.79
3 7.066 49.928 0.595 0.354 4.2
4 1.376 1.893 1.475 2.176 2.03
5 0.214 0.046 1.405 1.974 0.3
6 5.736 32.902 1.425 2.031 8.17
7 11.916 141.991 9.775 95.551 116.48
8 4.126 17.024 5.115 26.163 21.1
9 1.876 3.519 0.455 0.207 0.85
10 9.804 96.118 3.155 9.954 30.93
11 4.534 20.557 0.535 0.286 2.43
12 3.886 15.101 4.155 17.264 16.15
0.00 613.84 0.00 250.90 296.91
Sum
Elton, Gruber, Brown and Goetzmann 47
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
The sample variance and standard deviation of the stock A’s monthly return are:
( )
15 . 51
12
84 . 613
12
12
1
2
2
= =
÷
=
_
= t
A At
A
R R
o
% 15 . 7 15 . 51 = =
A
o
The sample variance (the answer to part 1.F) and standard deviation of the
market portfolio’s monthly return are:
( )
91 . 20
12
90 . 250
12
12
1
2
2
= =
÷
=
_
= t
m mt
m
R R
o
% 57 . 4 91 . 20 = =
m
o
The sample covariance of the returns on stock A and the market portfolio is:
( )( )  
74 . 24
12
91 . 296
12
12
1
= =
÷ ÷
=
_
= t
m mt A At
Am
R R R R
o
The sample correlation coefficient of the returns on stock A and the market
portfolio (the answer to part 1.D) is:
757 . 0
57 . 4 15 . 7
74 . 24
=
×
= =
m A
Am
Am
o o
o
µ
The sample beta of stock A (the answer to part 1.B) is:
183 . 1
91 . 20
74 . 24
2
= = =
m
Am
A
o
o

The sample alpha of stock A (the answer to part 1.A) is:
% 609 . 0 % 005 . 3 183 . 1 % 946 . 2 ÷ = × ÷ = ÷ =
m A A A
R R  o
Each month’s sample residual is security A’s actual return that month minus the
return that month predicted by the regression. The regression’s predicted monthly
return is:
mt A A edicted t A
R R  o ÷ =
Pr , ,
Elton, Gruber, Brown and Goetzmann 48
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
The sample residual for each month t is then:
edicted t A At At
R R
Pr , ,
÷ = c
So we have the following:
Month t
At
R
edicted t A
R
Pr , , At
c
2
At
c
1 12.05 13.92 1.87 3.5
2 15.27 6.48 8.79 77.26
3 4.12 2.24 6.36 40.45
4 1.57 4.69 3.12 9.73
5 3.16 4.61 1.45 2.1
6 2.79 4.63 7.42 55.06
7 8.97 8.62 0.35 0.12
8 1.18 3.11 1.93 3.72
9 1.07 3.48 2.41 5.81
10 12.75 6.68 6.07 36.84
11 7.48 2.31 5.17 26.73
12 0.94 1.97 1.02 1.04
Sum: 0.00 262.36
Since the sample residuals sum to 0 (because of the way the sample alpha and
beta are calculated), the sample mean of the sample residuals also equals 0 and
the sample variance and standard deviation of the sample residuals (the answer
to part 1.C) are:
( )
863 . 21
12
36 . 262
12 12
12
1
12
1 2
= = =
÷
=
_ _
= = t
At
t
A At
A
c c c
o
c
% 676 . 4 863 . 21 = =
A c
o
Elton, Gruber, Brown and Goetzmann 49
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
Repeating the above analysis for all the stocks in the problem yields:
Stock A Stock B Stock C
alpha ÷0.609% 2.964% ÷3.422%
beta 1.183 1.021 2.322
correlation
with market 0.757 0.684 0.652
standard deviation
of sample residuals
*
4.676% 4.983% 12.341%
with % 005 . 3 =
m
R and . 91 . 20
2
=
m
o
*
Note that most regression programs use N ÷ 2 for the denominator in the sample
residual variance formula and use N ÷ 1 for the denominator in the other variance
formulas (where N is the number of time series observations). As is explained in the
text, we have instead used N for the denominator in all the variance formulas. To
convert the variance from a regression program to our results, simply multiply the
variance by either
N
N 2 ÷
or
N
N 1 ÷
.
Chapter 7: Problem 2
A.
A.1
The Sharpe singleindex model's formula for a security's mean return is
R
+ =
R m
i
i i

o
Using the alpha and beta for stock A along with the mean return on the market
portfolio from Problem 1 we have:
% 946 . 2 005 . 3 183 . 1 609 . 0 = × + ÷ =
A
R
Similarly:
% 032 . 6 =
B
R ; % 556 . 3 =
C
R
Elton, Gruber, Brown and Goetzmann 50
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
The Sharpe singleindex model's formula for a security's variance of return is:
2 2 2 2
i m i i c
o o  o + =
Using the beta and residual standard deviation for stock A along with the variance
of return on the market portfolio from Problem 1 we have:
14 . 51 676 . 4 91 . 20 183 . 1
2 2 2
= + × =
A
o
Similarly:
62 . 46
2
=
b
o ; 0 . 265
2
=
c
o
A.2
From Problem 1 we have:
% 946 . 2 =
A
R ; % 031 . 6 =
B
R ; % 554 . 3 =
C
R
; ; 15 . 51
2
=
A
o 61 . 46
2
=
B
o 0 . 265
2
=
C
o
B.
B.1
According to the Sharpe singleindex model, the covariance between the returns
on a pair of assets is:
2
m j i ij
SIM o   o =
Using the betas for stocks A and B along with the variance of the market portfolio
from Problem 1 we have:
254 . 25 91 . 20 021 . 1 183 . 1 = × × =
AB
SIMo
Similarly:
433 . 57 =
AC
SIMo ; 568 . 49 =
BC
SIMo
Elton, Gruber, Brown and Goetzmann 51
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
B.2
The formula for sample covariance from the historical time series of 12 pairs of
returns on security i and security j is:
( )( )
12
12
1
_
=
÷ ÷
=
t
j jt i it
ij
R R R R
o
Applying the above formula to the monthly data given in Problem 1 for securities
A, B and C gives:
462 . 18 =
AB
o ; 618 . 61 =
AC
o ; 085 . 54 =
BC
o
C.
C.1
Using the earlier results from the Sharpe singleindex model, the mean monthly
return and standard deviation of an equally weighted portfolio of stocks A, B and
C are:
% 18 . 4 % 556 . 3
3
1
% 032 . 6
3
1
% 946 . 2
3
1
= × + × + × =
P
R
% 348 . 8
57 . 49
3
1
43 . 57
3
1
25 . 25
3
1
2 0 . 265
3
1
62 . 46
3
1
15 . 51
3
1
2 2 2 2 2 2
=


.

\

× 
.

\

+ × 
.

\

+ × 
.

\

× + × 
.

\

+ × 
.

\

+ × 
.

\

=
P
o
C.2
Using the earlier results from the historical data, the mean monthly return and
standard deviation of an equally weighted portfolio of stocks A, B and C are:
% 18 . 4 % 554 . 3
3
1
% 031 . 6
3
1
% 946 . 2
3
1
= × + × + × =
P
R
% 374 . 8
08 . 54
3
1
62 . 61
3
1
46 . 18
3
1
2 0 . 265
3
1
62 . 46
3
1
15 . 51
3
1
2 2 2 2 2 2
=


.

\

× 
.

\

+ × 
.

\

+ × 
.

\

× + × 
.

\

+ × 
.

\

+ × 
.

\

=
P
o
Elton, Gruber, Brown and Goetzmann 52
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
D.
The slight differences between the answers to parts A.1 and A.2 are simply due to
rounding errors. The results for sample mean return and variance from either the
Sharpe singleindex model formulas or the samplestatistics formulas are in fact
identical.
The answers to parts B.1 and B.2 differ for sample covariance because the Sharpe
singleindex model assumes the covariance between the residual returns of
securities i and j is 0 (cov(ci cj ) = 0), and so the singleindex form of sample
covariance of total returns is calculated by setting the sample covariance of the
sample residuals equal to 0. The samplestatistics form of sample covariance of
total returns incorporates the actual sample covariance of the sample residuals.
The answers in parts C.1 and C.2 for mean returns on an equally weighted portfolio
of stocks A, B and C are identical because the Sharpe singleindex model formula
for the mean return on an individual stock yields a result identical to that of the
samplestatistics formula for the mean return on the stock.
The answers in parts C.1 and C.2 for standard deviations of return on an equally
weighted portfolio of stocks A, B and C are different because the Sharpe single
index model formula for the sample covariance of returns on a pair of stocks yields
a result different from that of the samplestatistics formula for the sample
covariance of returns on a pair of stocks.
Chapter 7: Problem 3
Recall from the text that the Vasicek technique’s forecast of security i’s beta (
2 i
 )
is:
1
2
1
2
1
2
1
1
2
1
2
1
2
1
2 i
i i
i
i

o o
o

o o
o







×
+
+ ×
+
=
where
1
 is the average beta across all sample securities in the historical period (in
this problem referred to as the “market beta”),
1 i
 is the beta of security i in the
historical period,
2
1 
o is the variance of all the sample securities’ betas in the
historical period and is the square of the standard error of the estimate of beta
for security i in the historical period.
2
1 i 
o
If the standard errors of the estimates of all the betas of the sample securities in the
historical period are the same, then, for each security i, we have:
a
i
=
2
1 
o
where a is a constant across all the sample securities.
Elton, Gruber, Brown and Goetzmann 53
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
Therefore, we have for any security i:
( )
1 1 1
2
1
2
1
1
2
1
2
1
i i i
X X
a a
a
  
o
o

o




÷ + = ×
+
+ ×
+
=
This shows that, under the assumption that the standard errors of all historical betas
are the same, the forecasted beta for any security using the Vasicek technique is
a simple weighted average (proportional weighting) of
1
 (the “market beta”)
and
1 i
 (the security’s historical beta), where the weights are the same for each
security.
Chapter 7: Problem 4
Letting the historical period of the year of monthly returns given in Problem 1 equal
1 (t = 1), then the forecast period equals 2 and the Blume forecast equation is:
1 2
60 . 0 41 . 0
i i
  + =
Using the earlier answer to Problem 1 for the estimate of beta from the historical
period for stock A along with the above equation we obtain the stock’s
forecasted beta:
120 . 1 183 . 1 60 . 0 41 . 0 60 . 0 41 . 0
1 2
= × + = + =
A A
 
Similarly:
023 . 1
2
=
B
 ; 803 . 1
2
=
C

Chapter 7: Problem 5
A.
The singleindex model's formula for security i's mean return is
R
+ =
R m
i
i i

o
Since
Rm
equals 8%, then, e.g., for security A we have:
% =
+ =
x + =
R
+ =
R m
A
A A
14
12 2
8 5 . 1 2

o
Elton, Gruber, Brown and Goetzmann 54
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
Similarly:
% 4 . 13 =
B
R ; % 4 . 7 =
C
R ; % 2 . 11 =
D
R
B.
The singleindex model's formula for security i's own variance is:
. + =
2
e
2
m
2
i
2
i
i
o o

o
Since ǔm = 5, then, e.g., for security A we have:
( ) ( ) ( )
25 . 65
3 5 5 . 1
2 2 2
=
=
+ =
2
e
2
m
2
A
2
A
A
+ ×
o o

o
Similarly:
ǔ
2
B = 43.25; ǔ
2
C = 20; ǔ
2
D = 36.25
C.
The singleindex model's formula for the covariance of security i with security j is
o
 
o o
2
m
j i
ji ij
= =
Since ǔ
2
m = 25, then, e.g., for securities A and B we have:
75 . 48
25 3 . 1 5 . 1
=
=
=
2
m
B A
AB
× ×
o
 
o
Similarly:
ǔAC = 30; ǔAD = 33.75; ǔBC = 26; ǔBD = 29.25; ǔCD = 18
Chapter 7: Problem 6
A.
Recall that the formula for a portfolio's beta is:
 
i
i
N
1 = i
P
X
=
_
The weight for each asset (Xi) in an equally weighted portfolio is simply 1/N, where
N is the number of assets in the portfolio.
Elton, Gruber, Brown and Goetzmann 55
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
Since there are four assets in Problem 5, N = 4 and Xi equals 1/4 for each asset in
an equally weighted portfolio of those assets. So:
( )
125 . 1
5 . 4
4
1
9 . 0 8 . 0 3 . 1 5 . 1
4
1
4
1
4
1
4
1
4
1
=
=
=
=
D C B A P
×
+ + +
+ + +     
B.
Recall that the definition of a portfolio's alpha is:
o o i i
N
1 = i
P X
=
_
Using 1/4 as the weight for each asset, we have:
( )
5 . 2
10
4
1
4 1 3 2
4
1
4
1
4
1
4
1
4
1
=
=
=
=
D C B A P
×
+ + +
+ + +
o o o o o
C.
Recall that a formula for a portfolio’s variance using the singleindex model is:
_
=
+ =
N
i
e i m P P
i
X
1
2 2 2 2 2
o o  o
Using 1/4 as the weight for each asset, we have:
( ) ( ) ( ) ( ) ( ) ( )
( ) ( )
52 . 33
16 4 1 9
16
1
25 25 . 1
4
4
1
2
4
1
1
4
1
3
4
1
5 25 . 1
2
2
2
2
2
2
2
2
2
2 2 2
=
+ + + + × =

.

\

+ 
.

\

+ 
.

\

+ 
.

\

+ =
P
o
Elton, Gruber, Brown and Goetzmann 56
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
D.
Using the singleindex model’s formula for a portfolio’s mean return we have:
% 5 . 11
8 125 . 1 5 . 2
=
× + =
+ =
m P P P
R R  o
Chapter 7: Problem 7
Using
1 2
677 . 0 343 . 0
i i
  + = and the historical betas given in Problem 5 we can
forecast, e.g., the beta for security A:
3585 . 1
0155 . 1 343 . 0
5 . 1 677 . 0 343 . 0
677 . 0 343 . 0
1 2
=
+ =
× + =
+ =
A A
 
Similarly:
2231 . 1
2
=
B
 ; 8846 . 0
2
=
C
 ; 9523 . 0
2
=
D

Chapter 7: Problem 8
Using the historical betas given in Problem 5 and Vasicek’s formula, we can
forecast, e.g., the beta of security A:
( )
( ) ( )
( )
( ) ( )
2932 . 1
8795 . 0 4137 . 0
5 . 1 5863 . 0 1 4137 . 0
5 . 1
0441 . 0 0625 . 0
0625 . 0
1
0441 . 0 0625 . 0
0441 . 0
5 . 1
21 . 0 25 . 0
25 . 0
1
21 . 0 25 . 0
21 . 0
2 2
2
2 2
2
1
2
1
2
1
2
1
1
2
1
2
1
2
1
2
=
+ =
× + × =
×
+
+ ×
+
=
×
+
+ ×
+
=
×
+
+ ×
+
=
A
A A
A
A

o o
o

o o
o







Similarly:
1137 . 1
2
=
B
 ; 8683 . 0
2
=
C
 ; 9390 . 0
2
=
D

Elton, Gruber, Brown and Goetzmann 57
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 7
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 8
Chapter 8: Problem 1
Given the correlation coefficient of the returns on a pair of securities i and j, the
securities’ covariance can be expressed as the securities’ correlation coefficient
times the product of their standard deviations:
j i ij ij
o o µ o =
But if we assume that all pairs of securities have the same constant correlation, ,
*
µ
then the constantcorrelation expression for covariance is:
j i ij
CC o o µ o
*
=
Given the assumptions of the Sharpe singleindex model, the singleindex model’s
expression for the covariance between the returns on a pair of securites is:
j i jm im
m
m
m j jm
m
m i im
m
m
jm
m
im
m j i ij
SIM
o o µ µ
o
o
o o µ
o
o o µ
o
o
o
o
o
o   o
=
× × =
× × =
=
2
2 2
2
2 2
2
If the assumptions of both the constant correlation and singleindex model hold,
then we have
ij ij
SIM CC o o = :
j i jm im j i
o o µ µ o o µ =
*
or
jm im
µ µ µ =
*
This must hold for all pairs of securities, including i and j, i and k and j and k. So we
have:
jm im
µ µ µ =
*
km im
µ µ µ =
*
km jm
µ µ µ =
*
The only solution to the above set of equations is:
*
µ µ µ µ = = =
km jm im
Therefore, for any security i we have:
i
m m
i im
m
m i im
m
im
i
o
o
µ
o
o µ
o
o o µ
o
o
 × = = = =
*
2 2
In other words, given that all pairs of securities have the same correlation
coefficient and that the Sharpe singleindex model holds, each security’s beta is
proportional to its standard deviation, where the proportion is a constant across all
securities equal to
m
o
µ
*
.
Elton, Gruber, Brown and Goetzmann 59
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Chapter 8: Problem 2
Start with a general 3index model of the form:
i i i i i i
c I b I b I b a R + × + × + × + =
*
3
*
3
*
2
*
2
*
1
*
1
*
(1)
Set and define an index I2 which is orthogonal to I1 as follows:
1
*
1
I I =
t
d I I + × + =
1 1 0
*
2
¸ ¸ or ( )
1 1 0
*
2 2
I I d I
t
× + ÷ = = ¸ ¸
which gives:
2 1 1 0
*
2
I I I + × + = ¸ ¸
Substituting the above expression into equation (1) and rearranging we get:
( ) ( )
i i i i i i i i
c I b I b I b b b a R + × + × + × × + + × + =
*
3
*
3 2
*
2 1 1
*
2
*
1 0
*
2
*
¸ ¸
The first term in the above equation is a constant, which we can define as
'
1
a . The
coefficient in the second term of the above equation is also a constant, which we
can define as . We can then rewrite the above equation as:
'
1 i
b
i i i i i i
c I b I b I b a R + × + × + ×
'
+
'
=
*
3
*
3 2
*
2 1 1
(2)
Now define an index I3 which is orthogonal to I1 and I2 as follows:
t
e I I I + × + × + =
2 2 1 1 0
*
3
u u u or ( )
2 2 1 1 0
*
3 3
I I I e I
t
× + × + ÷ = = u u u
which gives:
3 2 2 1 1 0
*
3
I I I I + × + × + = u u u
Substituting the above expression into equation (2) and rearranging we get:
( )
i i i i i i i i i
c I b I b b I b b b a R + × + × × + + × 
.

\

× +
'
+ 
.

\

× +
'
=
3
*
3 2 2
*
3
*
2 1 1 3 1 0 3
u u u
In the above equation, the first term and all the coefficients of the new orthogonal
indices are constants, so we can rewrite the equation as:
i i i i i i
c I b I b I b a R + × + × + × + =
3 3 2 2 1 1
Elton, Gruber, Brown and Goetzmann 60
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Chapter 8: Problem 3
Recall from the earlier chapter on the singleindex model that an expression for
the covariance of returns on two securities i and j is:
( ) ( )   ( )    
j i m m j i m m i j m m j i ij
e e R R e R R e R R E E E E
2
+ ÷ + ÷ +
(
¸
(
¸
÷ =     o
The first term contains the variance of the market portfolio, the second two terms
contain the covariance of the market portfolio with the residuals and the last term
is the covariance of the residuals.
Given that one of the model’s assumptions is that the covariance of the market
portfolio with the residuals is zero and that, from the problem, the covariance of
the residuals equals a constant K, the derived covariance between the two
securities is:
K
m j i ij
+ =
2
o   o
One expression for the variance of a portfolio is:
__ _
=
=
= =
+ =
N
j
N
j k
k
jk k j
N
i
i i P
X X X
1 1 1
2 2 2
o o o
Recalling that the singleindex model’s expression for the variance of a security is
2 2 2 2
ei m i i
o o  o + = and substituting that expression and the derived expression for
covariance into the above equation and rearranging gives:



.

\

+ + =
+ +


.

\



.

\

=
+ + =
+ + + =
__ _
__ _ _ _
__ _ __
_ _ _ _ _
=
=
= =
=
=
= = = =
=
=
= = = =
= =
=
=
=
= = =
N
j
N
j k
k
k j
N
i
ei i m P
N
j
N
j k
k
k j
N
i
ei i m
N
i
i i
N
i
i i
N
j
N
j k
k
k j
N
i
ei i
N
i
N
j
m j i j i
N
j
N
j
N
j k
k
k j
N
j k
k
m k j k j
N
i
ei i
N
i
m i i P
X X K X
K X X X X X
K X X X X X
K X X X X X X
1 1 1
2 2 2 2
1 1 1
2 2 2
1 1
1 1 1
2 2
1 1
2
1 1 1
2
1
2 2
1
2 2 2 2
o o 
o o  
o o  
o   o o  o
_
1
Elton, Gruber, Brown and Goetzmann 61
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Chapter 8: Problem 4
Using the result from Problem 2, we have:
i i i i i i
c I b I b I b a R + × + × + × + =
3 3 2 2 1 1
Since the residual ci always has a mean of zero (by construction if necessary), we
have the following expression for expected return:
3 3 2 2 1 1
I b I b I b a R
i i i i i
× + × + × + =
The variance formula is:
( ) ( )
( ) ( ) ( ) ( )
(
¸
(
¸
+ ÷ + ÷ + ÷ =
(
¸
(
¸
× + × + × + ÷ + × + × + × + =
2
3 3 3 2 2 2 1 1 1
2
3 3 2 2 1 1 3 3 2 2 1 1
2
E
E
i i i i
i i i i i i i i i i
c I I b I I b I I b
I b I b I b a c I b I b I b a o
Carrying out the squaring, noting that the indices are all orthogonal with each
other and making the usual assumption that the residual is uncorrelated with any
index gives us:
2 2
3
2
3
2
2
2
2
2
1
2
1
2
ci I i I i I i i
b b b o o o o o + + + =
The covariance formula is:
( ) ( )
( ) ( )
( ) ( ) ( ) ( ) ( ) ( ) ( ) ( )  
j j j j i i i i
j j j j j j j j j
i i i i i i i i i
i
c I I b I I b I I b c I I b I I b I I b
I b I b I b a c I b I b I b a
I b I b I b a c I b I b I b a
+ ÷ + ÷ + ÷ × + ÷ + ÷ + ÷ =
(
(
¸
(
¸
× + × + × + ÷ + × + × + × + ×
× + × + × + ÷ + × + × + × +
=
3 3 3 2 2 2 1 1 1 3 3 3 2 2 2 1 1 1
3 3 2 2 1 1 3 3 2 2 1 1
3 3 2 2 1 1 3 3 2 2 1 1
2
E
E o
Carrying out the multiplication, noting that the indices are all orthogonal with
each other, making the usual assumption that the residuals are uncorrelated with
any index and assuming that the residuals are uncorrelated with each other gives
us:
2
3 3 3
2
2 2 2
2
1 1 1 I j i I j i I j i ij
b b b b b b o o o o + + =
Elton, Gruber, Brown and Goetzmann 62
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Chapter 8: Problem 5
The formula for a security's expected return using a general twoindex model is:
2 2 1 1
I b I b a R
i i i i
× + × + =
Using the above formula and data given in the problem, the expected return for,
e.g., security A is:
% 12
4 9 . 0 8 8 . 0 2
2 2 1 1
=
× + × + =
× + × + = I b I b a R
A A A A
Similarly:
% 17 =
B
R ; % 6 . 12 =
C
R
The twoindex model’s formula for a security’s own variance is:
2 2
2
2
2
2
1
2
1
2
ci I i I i i
b b o o o o + + =
Using the above formula, the variance for, e.g., security A is:
( ) ( ) ( ) ( ) ( )
6225 . 11 4 0625 . 5 56 . 2
2 5 . 2 9 . 0 2 8 . 0
2 2 2 2 2
2 2
2
2
2
2
1
2
1
2
= + + =
+ + =
+ =
cA I A I A A
b b o o o o
Similarly, ǔ
2
B = 16.4025, and ǔ
2
C = 13.0525.
C. The twoindex model's formula for the covariance of security i with security j is:
2
2 2 2
2
1 1 1 I j i I j i ijj
b b b b o o o + =
Using the above formula, the covariance of, e.g., security A with security B is:
( )( )( ) ( )( )( )
8325 . 10 3125 . 7 52 . 3
5 . 2 3 . 1 9 . 0 2 1 . 1 8 . 0
2 2
2
2 2 2
2
1 1 1
= + =
+ =
+ =
I B A I B A AB
b b b b o o o
Similarly, ǔAC = 9.0675, and ǔBC = 12.8975.
Elton, Gruber, Brown and Goetzmann 63
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Chapter 8: Problem 6
For an industryindex model, the text gives two formulas for the covariance
between securities i and k. If firms i and k are both in industry j, the covariance
between their securities' returns is given by:
2 2
Ij kj ij m km im ik
b b b b o o o + =
Otherwise, if the firms are in different industries, the covariance of their securities'
returns is given by:
2
m km im ik
b b o o =
If only firms A and B are in the same industry, then:
( )( )( ) ( )( )( )
8325 . 10 3125 . 7 52 . 3
5 . 2 3 . 1 9 . 0 2 1 . 1 8 . 0
2 2
2
2 2 2
2
= + =
+ =
+ =
I B A m Bm Am AB
b b b b o o o
The second formula should be used for the other pairs of firms:
( )( )( ) 88 . 2 2 9 . 0 8 . 0
2
2
= =
=
m Cm Am AC
b b o o
( )( )( ) 96 . 3 2 9 . 0 1 . 1
2
2
= =
=
m Cm Bm BC
b b o o
Chapter 8: Problem 7
The answers for this problem are found in the same way as the answers for problem 6,
except that now only firms B and C are in the same industry. So for firms B and C, the
covariance between their securities' returns is:
( )( )( ) ( )( )( )
8975 . 12 9375 . 8 96 . 3
5 . 2 1 . 1 3 . 1 2 9 . 0 1 . 1
2 2
2
2 2 2
2
= + =
+ =
+ =
I C B m Cm Bm BC
b b b b o o o
Elton, Gruber, Brown and Goetzmann 64
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
The other formula should be used for the other pairs of firms:
( )( )( ) 52 . 3 2 1 . 1 8 . 0
2
2
= =
=
m Bm Am AB
b b o o
( )( )( ) 88 . 2 2 9 . 0 8 . 0
2
2
= =
=
m Cm Am AC
b b o o
Chapter 8: Problem 8
To answer this problem, use the procedure described in Appendix A of the text.
First, I1 is defined as being equal to I
*
1 , then I
*
2 is regressed on I1 to obtain the given
regression equation. Since dt is uncorrelated with I1 by the techniques of regression
analysis, dt is an orthogonal index to I1. So, define I2 = dt. Then express the given
regression equation as:
I
*
2 = 1 + 1.3 I1 + I2.
Now, substitute the above equation for I
*
2 into the given multiindex model and
simplify:
i
R = 2 + 1.1 I
*
1 + 1.2 I
*
2 + ci
= 2 + 1.1 I1 + 1.2 (1 + 1.3 I1 + I2) + ci
= 2 + 1.1 I1 + 1.2 + 1.56 I1 + 1.2 I2 + ci
= 3.2 + 2.66 I1 + 1.2 I2 + ci
The twoindex model has now been transformed into one with orthogonal indices
I1 and I2, where I1 = I
*
1, and I2 = dt = I
*
2  1  1.3 I1.
Elton, Gruber, Brown and Goetzmann 65
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Elton, Gruber, Brown and Goetzmann 66
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 8
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 9
Chapter 9: Problem 1
In the table below, given that the riskless rate equals 5%, the securities are ranked
in descending order by their excess return over beta.
Security Rank i
F i
R R ÷
i
F i
R R

÷ ( )
2
ei
i F i
R R
o
 ÷
2
2
ei
i
o

( )
_
=


.

\

÷
i
j ej
j F j
R R
1
2
o

_
=


.

\

i
j ej
j
1
2
2
o

Ci
1 1 10 10.0000 0.3333 0.0333 0.3333 0.0333 2.5000
6 2 9 6.0000 1.3500 0.2250 1.6833 0.2583 4.6980
2 3 7 4.6667 0.5250 0.1125 2.2083 0.3708 4.6910
5 4 4 4.0000 0.2000 0.0500 2.4083 0.4208 4.6242
4 5 3 3.7500 0.2400 0.0640 2.6483 0.4848 4.5286
3 6 6 3.0000 0.3000 0.1000 2.9483 0.5848 4.3053
The numbers in the column above labeled Ci were obtained by recalling from the
text that, if the Sharpe singleindex model holds:
( )


.

\



.

\

+


.

\



.

\

÷
=
_
_
=
=
i
j ej
j
m
i
j ej
j F j
m
i
R R
C
1
2
2
2
1
2
2
1
o

o
o

o
Thus, given that = 10:
2
m
o
500 . 2
333 . 1
333 . 3
0333 . 0 10 1
3333 . 0 10
1
= =
× +
×
= C
698 . 4
583 . 3
833 . 16
2583 . 0 10 1
6833 . 1 10
2
= =
× +
×
= C
etc.
With no short sales, we only include those securities for which
i
i
F i
C
R R
>
÷

. Thus,
only securities 1 and 6 (the highest and second highest ranked securities in the
above table) are in the optimal (tangent) portfolio. We could have stopped our
calculations after the first time we found a ranked security for which
i
i
F i
C
R R
<
÷

,
(in this case the third highest ranked security, security 2), but we did not so that we
could demonstrate that
i
i
F i
C
R R
<
÷

for all of the remaining lower ranked securities
as well.
Elton, Gruber, Brown and Goetzmann 67
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
Since security 6 (the second highest ranked security, where i = 2) is the last ranked
security in descending order for which
i
i
F i
C
R R ÷
>

, we set C
*
= C2 = 4.698 and
solve for the optimum portfolio’s weights using the following formulas:


.

\

÷
÷


.

\

=
*
2
C
R R
Z
i
F i
ei
i
i

o

_
=
=
2
1 i
i
i
i
Z
Z
X
This gives us:
( ) 1767 . 0 698 . 4 10
30
1
1
= ÷ 
.

\

= Z
( ) 1953 . 0 698 . 4 6
10
5 . 1
2
= ÷ 
.

\

= Z
3720 . 0 1953 . 0 1767 . 0
2 1
= + = + Z Z
475 . 0
3720 . 0
1767 . 0
1
= = X
525 . 0
3720 . 0
1953 . 0
2
= = X
Since i = 1 for security 1 and i = 2 for security 6, the optimum (tangent) portfolio
when short sales are not allowed consists of 47.5% invested in security 1 and 52.5%
invested in security 6.
Chapter 9: Problem 2
This problem uses the same input data as Problem 1. When short sales are allowed,
all securities are included and C
*
is equal to the value of Ci for the lowest ranked
security. Referring back to the table given in the answer to Problem 1, we see that
the lowest ranked security is security 3, where i = 6. Therefore, we have C
*
= C6 =
4.3053.
Elton, Gruber, Brown and Goetzmann 68
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
To solve for the optimum portfolio’s weights, we use the following formulas:




÷
÷




=
*
2
C
R R
Z
F i i
i

. \ . \
i
ei

o
and
_
=
=
6
1 i
i
i
i
Z
Z
X (for the standard definition of short sales)
or
_
=
=
6
1 i
i
i
i
Z
Z
X (for the Lintner definition of short sales)
So we have:
( ) 1898 . 0 3053 . 4 10
30
1
1
= ÷ 
.

\

= Z
( ) 2542 . 0 3053 . 4 6
10
5 . 1
2
= ÷ 
.

\

= Z
( ) 0271 . 0 3053 . 4 667 . 4
20
5 . 1
3
= ÷ 
.

\

= Z
( ) 0153 . 0 3053 . 4 4
20
1
4
÷ = ÷ 
.

\

= Z
( ) 0444 . 0 3053 . 4 75 . 3
10
8 . 0  
Z
5
÷ = ÷ 
.
\
=
( ) 0653 . 0 3053 . 4 3
40
0 . 2
6
÷ = ÷ 
.

\

= Z
3461 . 0 0653 . 0 0444 . 0 0153 . 0 0271 . 0 2542 . 0 1898 . 0
6
= ÷ ÷ ÷ + + =
_ i
Z
1 = i
5961 . 0 0653 . 0 0444 . 0 0153 . 0 0271 . 0 2542 . 0 1898 . 0
6
1
= + + + + + =
_
= i
i
Z
Elton, Gruber, Brown and Goetzmann 69
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
This gives us the following weights (by rank order) for the optimum portfolios under
ither the standard definition of short sales or the Lintner definition of short sales:
Standard Definition Lintner Definition
rity 1 (i = 1)
e
5484 . 0
3461 . 0
1898 . 0
1
= = X 3184 . 0
5961 . 0
1898 . 0
1
= = X Secu
7345 . 0
3461 . 0
2542 . 0
2
= = X 4264 . 0
5961 . 0
2542 . 0
2
= = X Security 6 (i = 2)
Security 2 (i = 3) 0783 . 0
1
=
346 . 0
0271 . 0
3
= X 0455 . 0
5961 . 0
3
= = X
0271 . 0
ecurity 5 (i = 4) 0442 . 0
3461 . 0
0153 . 0
4
÷ =
÷
= X 0257 . 0
5961 . 0
0153 . 0
4
÷ =
÷
= X S
1283 . 0
3461 . 0
0444 . 0
5
÷ =
÷
= X 0745 . 0
5961 . 0
0444 . 0
5
÷ =
÷
= X Security 4 (i = 5)
ecurity 3 (i = 6) 1887 . 0
3461 . 0
0653 . 0
6
÷ =
÷
= X 1095 . 0
5961 . 0
0653 . 0
6
÷ =
÷
= X S
Chapter 9: Problem 3
With short sales allowed but no riskless lending or borrowing, the optimum portfolio
depends on the investor’s utility function and will be found at a point along the
nimumvariance frontier of ris assets, which is the efficient
nding and borrowing do not exist. As is described in the text,
the entire efficient frontier of risky a ets can be delineated with various
two efficient portfolios on the frontier. One such efficient
in Problem 2. By simply solving oblem 2 using a different
value for RF , another portfolio on the effi ient frontier can be found and then the
entire efficient frontier can be traced u ombinations of those two efficient
upper half of the mi ky
frontier when riskless le
ss
combinations of any
portfolio was found Pr
c
sing c
portfolios.
Elton, Gruber, Brown and Goetzmann 70
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
Chapter 9: Problem 4
In the table below, given that the riskless rate equals 5%, the securities are ranked
i
in descending order by their excess return over standard deviation.
( )
_

÷
i
F j
R R
=


.

\
j j 1
o
i
F i
R R
o
÷
µ µ
µ
i + ÷ 1
F i
R R ÷ Security Rank C
10 1.00
i
1 1 1.00 0.5000 0.5000
2 2 15 1.00 2.00 0.3333 0.6667
5 3 5 1.00 3.00 0.2500 0.7500
6 4 9 0.90 3.90 0.2000 0.7800
4 5 7 0.70 4.60 0.1667 0.76 8 6
3 6 13 0.65 5.25 0.1429 0.7502
7 7 11 0.55 5.80 0.1250 0.7250
The numbers in the column above labeled Ci were obtained by recalling from the
nstantcorrelation model h text that, if the co olds:
( )


.

\



.

\
= j
j
1
o

÷
×


.

\

+ ÷
=
_
i
j
F
i
R R
i
C
1 µ µ
µ
us, given that µ = 0.5 for all pairs of securities: Th
5000 . 0 0 . 1 5 . 0
1
= × = C
6667 . 0 0 . 2 3333 . 0
2
= × = C
etc.
With no short sales, we only include those securities for which
i
i
F i
C
R R
>
÷
o
. Thus,
only securities 1, 2, 5 and 6 (the four highest ranked securities in the above table)
are in the optimal (tangent) portfolio. We could have stopped our calculations
after the first time we found a ranked security for which
i
i
F i
C
R R
<
÷
o
,
id not so tha
(in this case
the fifth highest ranked security, security 4), but we d t we could
demonstrate that
i
i
F i
C
R R
<
÷
o
for all of the remaining lower ranked securities as
well.
Elton, Gruber, Brown and Goetzmann 71
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
Since security 6 (the fourth highest ranked security, where i = 4) is the last ranked
security in descending order for which
i
i
F i
C >
o
, we set C
*
= C4 = 0.78 and solve
r the optimum portfolio’s weights using the following formulas:
R R ÷
fo
( )


.





=
R
Z
i
\
÷
÷

.
\
÷
*
1
1
C
R
i
F
i
i
o o µ
_
=
=
4
1 i
i
i
i
X
Z
Z
This g es us: iv
( )( )
( 0 1÷

) 0440 . 0 78 .
10 5 . 0
1
1
=


.
\
= Z

( )( )
( ) 029 . 0 78 . 0 1
1
2
= ÷




= Z 3
15 5 . 0
. \
( )( )
( ) 0880 . 0 78 . 0 1
5 5 . 0
1
3
= ÷


.

\

= Z
( )( )
( ) 0240 . 0 78 . 0 9 . 0
10 5 . 0
4
\
1  
= ÷


.
= Z
2 1
1853 . 0 0240 . 0 0880 . 0 0293 . 0 0440 . 0
4 3
= + + Z Z + + = + + Z Z
2375 . 0
1853 . 0
0440 . 0
1
= = X
1581 . 0
1853 . 0
0293 . 0
2
= = X
4749 . 0
0880 . 0
3
= = X
1853 . 0
1295 . 0
53
=
18 . 0
0240 . 0
4
= X
Since i = 1 for security 1, i = 2 for security 2, i = 3 for security 5 and i = 4 for security 6,
the optimum (tangent) portfolio when short sales are not allowed consists of
23.75% invested in security 1, 15.81% % invested in security 2, 47.49% % invested in
security 5 and 12.95% invested in security 6.
Elton, Gruber, Brown and Goetzmann 72
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
Chapter 9: Problem 5
This problem uses the same input data a 4. When short sales are allowed,
all securities are included and C is equal to the value of Ci for t
security. Referring back to the table given in the answer to Prob
s Problem
*
he lowest ranked
lem 4, we see that
e lowest ranked security is security 7, where i = 7. Therefore, we have C
*
= C7 =
0.725.
To solve for the optimum portfolio’s weigh , we use the following formulas:
th
ts
( )


.

\

÷
÷


.

\

÷
=
*
1
1
C
R R
Z
i
F i
i
i
o o µ
and
_
=
=
7
1 i
i
i
i
Z
Z
X (for the standard de tion of short sales)
or
fini
_
=
=
7
1 i
i
i
i
Z
Z
X (for the Lintner definition of short sales)
o we have: S
( )( )
( ) 0550 . 0 725 . 0 1
10 5 . 0
1
1
= ÷


.

\

= Z
( )( )
( ) 0367 . 0 725 . 0 1
15 5 . 0
1
2
= ÷


.

\

= Z
( )( )
( ) 1100 . 0 725 . 0 1
5 5 . 0
1
3
= ÷


.

\

= Z
( )( )
( ) 0350 . 0 725 . 0 9 . 0
10 5 . 0
1
4
= ÷


.

\

= Z
( )( )
( ) 0050 . 0 725 . 0 7 . 0
10 5 . 0
1
5
÷ = ÷


.

\

= Z
( )( )
( ) 0075 . 0 725 . 0 Z 65 . 0
20 5 . 0
1
6
÷ = ÷


.

\

=
( )( )
( ) 0175 . 0 725 . 0 Z 55 . 0
20 5 . 0
1
7
÷ = ÷


.

\

=
2067 . 0 0175 . 0 0075 . 0 0050 . 0 0350 . 0 1100 . 0 0367 . 0 0550 . 0
7
= ÷ ÷ ÷ + + + =
_ i
Z
1 = i
2667 . 0 0175 . 0 0075 . 0 0050 . 0 0350 . 0 1100 . 0 0367 . 0 0550 . 0
7
1
= + + + + + + =
_
= i
i
Z
Elton, Gruber, Brown and Goetzmann 73
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
Elton, Gruber, Brown and Goetzmann 74
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 9
ing weights (by rank order) for the optimum portfolios under
ither the standard definition of short sales or the Lintner definition of short sales:
This gives us the follow
e
Standard Definition Lintner Definition
Security 1 (i = 1) 2661 . 0
0550 . 0
= = X
2067 . 0
1
2062 . 0
0550 . 0
= = X
2667 . 0
1
Security 2 (i = 2) 1776 . 0
2067 . 0
0367 . 0
= = X 1376 . 0
2667 . 0
0367 . 0
= = X
2 2
Security 5 (i = 3) 5322 . 0
2067 . 0
1100 . 0
3
= = X 4124 . 0
2667 . 0
1100 . 0
3
= = X
Security 6 (i = 4) 1703 . 0
0
=
2067 . 0
035 . 0
4
= X 13 . 0
0350 . 0
= = X 12
2667 . 0
4
ty 4 (i = 5) 0242 . 0
2067 . 0
0050 . 0
5
÷ = = X 0187 . 0 Securi
2667 . 0
5
0050 . 0
÷ = = X
Security 3 (i = 6) 0363 . 0
2067 . 0
0075 . 0
6
÷ = = X 0281 . 0
2667 . 0
0075 . 0
6
÷ = = X
0847 . 0
2067 . 0
0175 . 0
7
÷ = = X 0656 . 0
2667 . 0
0175 . 0
7
÷ = = X Security 7 (i = 7)
ed but no riskless lending or bo owing, the optimum portfolio
depends on the investor’s utility function and will be found at a point along the
nimumvariance frontier of risky a ets, which is the efficient
nding and borrowing do not exist. As is described in the text,
the entire efficient frontier of risky assets can be delineated with various
two efficient portfolios on the frontier. One such efficient
portfolio was found in Problem 5. By simply solving Problem 5 using a different
portfolio on the efficient frontier can be found and then the
r can be traced using combinations of those two efficient
portfolios.
Chapter 9: Problem 6
With short sales allow rr
upper half of the mi ss
frontier when riskless le
combinations of any
value for RF , another
entire efficient frontie
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 10
Chapter 10: Problem 1
Expected utility of investment A = 1/3 × ÷7.5 + 1/3 × ÷12.5 + 1/3 × ÷31.5 = ÷17.0
Expected utility of investment B = 1/4 × ÷4.0 + 1/2 × ÷17.5 + 1/4 × ÷40.0 = ÷19.75
Expected utility of investment C = 1/5 × 0.5 + 3/5 × ÷31.5 + 1/5 × ÷144.0 = ÷47.8
Investment A is preferred because it has the highest level of expected utility.
Chapter 10: Problem 2
Expected utility of investment A = 1/3 × ÷0.45 + 1/3 × ÷0.41 + 1/3 × ÷0.33 = ÷0.40
Expected utility of investment B = 1/4 × ÷0.50 + 1/2 × ÷0.38 + 1/4 × ÷0.32 = ÷0.39
Expected utility of investment C = 1/5 × ÷1 + 3/5 × ÷0.33 + 1/5 × ÷0.24 = ÷0.45
Investment B is preferred because it has the highest level of expected utility.
Chapter 10: Problem 3
Expected utility of investment A = 2/5 × 12.04 + 1/5 × 16 + 2/5 × 20.16 = 16.08
Expected utility of investment B = 1/2 × 9 + 1/4 × 18.24 + 1/4 × 24 = 15.06
Investment A is preferred because it has the highest level of expected utility.
Chapter 10: Problem 4
For an investor to be indifferent, the expected utility of investment B must be set
equal to that of investment A. Referring back to Problem 3, we see that the given
probabilities are for the first two of the three outcomes in investment B. So we
need to solve for the probabilities of those two outcomes that make investment B’s
expected utility level equal to that of A’s. Since the last outcome in investment B
has a probability of 1/4, the first two probabilities must sum to 3/4. Therefore we
have:
X × 9 + (3/4 ÷X) × 18.24 + 1/4 × 24 = 16.08
Elton, Gruber, Brown and Goetzmann 75
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 10
Solving for X:
X = 0.39
Therefore, the first outcome’s probability of 0.5 would have to be reduced by 0.11
to 0.39, and the second outcome’s probability of 0.25 would have to be increased
by 0.11 to 0.36.
Chapter 10: Problem 5:
Given , then ( )
2 / 1 ÷
= W W U ( )
2 / 3
2
1
÷
÷ = ' W W U and ( )
2 / 5
4
3
÷
= ' ' W W U . Therefore:
( )
1
2 / 3
2 / 5
2
3
2
1
4
3
÷
÷
÷
=
÷
÷
= W
W
W
W A
( ) 0
2
3
2
< ÷ = '
÷
W W A
( )
2
3
2
1
4
3
2 / 3
2 / 3
=
÷
÷
=
÷
÷
W
W
W R
( ) 0 = ' W R
Therefore the utility function exhibits decreasing absolute risk aversion and
constant relative risk aversion.
Chapter 10: Problem 6
Given , then and ( )
bW
ae W U
÷
= ( )
bW
abe W U
÷
÷ = ' ( )
bW
e ab W U
÷
= ' '
2
. If the investor
prefers more to less, then U ; if the investor is also risk averse, then ( ) 0 > ' W ( ) 0 < ' ' W U .
Since , for and 0 >
÷bW
e U ( ) ' W 0 > ( ) 0 < ' ' W U we need 0 > ÷ ab and ab . Since
, this means that a must be negative (a < 0), which in turn means that b
must be positive (b > 0).
0 <
2
0
2
> b
Elton, Gruber, Brown and Goetzmann 76
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 10
Chapter 10: Problem 7
Given , then ( )
cW
be a W U + = ( )
cW
bce W U = ' and ( )
cW
e bc W U
2
= ' ' . If the investor
prefers more to less, then ; if the investor is also risk averse, then ( ) 0 > ' W U ( ) 0 < ' ' W U .
Since , for and 0 >
cW
e ' W U ( ) 0 > ( ) 0 < ' ' W U we need and . Since
, this means that b must be negative (b < 0), which in turn means that c
must also be negative (c < 0). Furthermore, for
0 > bc 0 <
2
bc
0
2
> c
( ) 0 > W U , we need
cW
be a > , since
when b < 0. 0 <
cW
be
Regarding the utility function’s properties of absolute and relative risk aversion, we
have:
( ) c
bce
e bc
W A
cW
cW
÷ =
÷
=
2
( ) 0 = ' W A
( ) cW
bce
We bc
W R
cW
cW
÷ =
÷
=
2
( ) 0 > ÷ = ' c W R
Therefore the utility function exhibits constant absolute risk aversion and increasing
relative risk aversion (since c < 0).
Chapter 10: Problem 8
Given and W > 0, then: ( )
2 / 1 ÷
÷ = W W U
( ) 0
2
1
2 / 3
> = '
÷
W W U (individual prefers more wealth to less)
( ) 0
4
3
2 / 5
< ÷ = ' '
÷
W W U (individual is risk averse)
( )
1
2 / 3
2 / 5
2
3
2
1
4
3
÷
÷
÷
= = W
W
W
W A
( ) 0
2
3
2
< ÷ = '
÷
W W A (decreasing absolute risk aversion)
Elton, Gruber, Brown and Goetzmann 77
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 10
( )
2
3
2
1
4
3
2 / 3
2 / 3
= =
÷
÷
W
W
W R
(constant relative risk aversion) ( ) 0 = ' W R
Chapter 10: Problem 9
Given and W > 0, then: ( )
W
e W U
÷
÷ =
(individual prefers more wealth to less) ( ) 0 > = '
÷W
e W U
(individual is risk averse) ( ) 0 < ÷ = ' '
÷W
e W U
( ) 1 = =
÷
÷
W
W
e
e
W A
(constant absolute risk aversion) ( ) 0 = ' W A
( ) W
e
We
W R
W
W
= =
÷
÷
(increasing relative risk aversion) ( ) 0 1> = ' W R
Chapter 10: Problem 10
The investor will prefer the investment that maximizes expected utility of terminal
wealth. Recall that the formula for expected utility of wealth (E[U(W)]) is:
( )   ( ) ( )
_
× =
W
W P W U W U E
where each P(W) is the probability associated with each particular outcome of
wealth (W). Since , we have: ( )
2
05 . 0 W W W U ÷ =
Investment A:
( )   ( ) ( ) ( )
525 . 4
3 . 0 5 5 . 0 55 . 4 2 . 0 75 . 3
3 . 0 10 05 . 0 10 5 . 0 7 05 . 0 7 2 . 0 5 05 . 0 5 E
2 2 2
=
× + × + × =
× × ÷ + × × ÷ + × × ÷ = W U
Elton, Gruber, Brown and Goetzmann 78
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 10
Investment B:
( )   ( ) ( ) ( )
635 . 4
1 . 0 95 . 4 6 . 0 8 . 4 3 . 0 2 . 4
1 . 0 9 05 . 0 9 8 . 0 8 05 . 0 8 3 . 0 6 05 . 0 6 E
2 2 2
=
× + × + × =
× × ÷ + × × ÷ + × × ÷ = W U
Investment B is preferred over investment A since B provides higher expected utility.
Chapter 10: Problem 11
To solve this problem, set the expected utility of investment A in Problem 10 equal
to 4.635 (the expected utility of investment B) and solve for the value of the first
outcome in investment A:
( ) ( ) ( ) 635 . 4 3 . 0 10 05 . 0 10 5 . 0 7 05 . 0 7 2 . 0 05 . 0
2 2 2
= × × ÷ + × × ÷ + × ÷ X X
635 . 4 5 . 1 275 . 2 01 . 2 . 0
2
= + + ÷ X X
0 86 20
2
= + ÷ X X
The equation above is a quadratic equation with two roots. Using the quadratic
formula, the roots are found to be 6.26 and 13.74. So, the minimum amount that
the first outcome of investment A would have to change by for the investor to be
indifferent between investments A and B would be $6.26 ÷ $5 = $1.26 (an increase),
since both investments would then provide the same level of expected utility.
Elton, Gruber, Brown and Goetzmann 79
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 10
Elton, Gruber, Brown and Goetzmann 80
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 10
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 11
Chapter 11: Problem 1
Cumulative Probability Cumulative Cumulative Probability
Outcome A B C A B C
4% 0.2 0.0 0.0 0.2 0.0 0.0
5% 0.2 0.1 0.0 0.4 0.1 0.0
6% 0.5 0.4 0.4 0.9 0.5 0.4
7% 0.5 0.6 0.7 1.4 1.1 1.1
8% 0.9 0.9 0.9 2.3 2.0 2.0
9% 0.9 1.0 0.9 3.2 3.0 2.9
10% 1.0 1.0 1.0 4.2 4.0 3.9
No investment exhibits firstorder stochastic dominance.
Using secondorder stochastic dominance, C > B > A.
Chapter 11: Problem 2
Roy’s safetyfirst criterion is to minimize Prob(RP < RL). If RL = 5%, then for the
investments in Problem 1 we have:
Prob(RA < 5%) = 0.2
Prob(RB < 5%) = 0.0
Prob(RC < 5%) = 0.0
Thus, using Roy’s safetyfirst criterion, investments B and C are preferred over
investment A, and the investor would be indifferent to choosing either investment
B or C.
Chapter 11: Problem 3
Kataoka's safetyfirst criterion is to maximize RL subject to Prob(RP < RL) s 1 o. If o =
10%, then for each investment in Problem 1 the maximum RL is:
3.99% for A
5.99% for B
5.99% for C
Thus, B and C are preferred to A, but are indistinguishable from each other.
Elton, Gruber, Brown and Goetzmann 81
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 11
Chapter 11: Problem 4
Employing Telser's criterion, we see that Project A in Problem 1 does not satisfy the
constraint Prob(Rp 5%) 10%. Thus it is eliminated. Between B and C, Project C
has higher expected return (7.1% compared to 7%). Thus it is preferred using
Telser’s criterion of maximizing Rp subject to the constraint.
s s
Chapter 11: Problem 5
The geometric mean returns of the investments shown in Problem 1 are:
A
G
R = (1.04)
.2
(1.06)
.3
(1.08)
.4
(1.1)
.1
 1 = .0678 (6.78%)
B
G
R = (1.05)
.1
(1.06)
.3
(1.07)
.2
(1.08)
.3
(1.09)
.1
 1 = .0699 (6.99%)
C
G
R = (1.06)
.4
(1.07)
.3
(1.08)
.2
(1.1)
.1
 1 = .0709 (7.09%).
Thus, C > B > A.
Chapter 11: Problem 6
cumulative probability
outcome A B C
3% 0.4 0.0 0.0
4% 0.7 0.0 0.0
5% 0.7 0.1 0.1
6% 0.8 0.3 0.1
7% 0.9 0.3 0.2
8% 0.9 0.4 0.4
9% 1.0 0.6 0.6
10% 1.0 1.0 0.6
11% 1.0 1.0 1.0
Since, with investment B, the cumulative probability at any outcome is never
greater than, and is sometimes less than, the cumulative probability with
investment A, B is preferred to A under firstorder stochastic dominance (assuming
investors prefer more to less). Similarly, since the cumulative probability associated
with investment C is never greater than, and is sometimes less than, that for
investment B, C is preferred to B under firstorder stochastic dominance. So the
ordering is C > B > A. Since these investments are ordered by firstorder stochastic
dominance, the preference ordering is preserved under secondorder stochastic
dominance.
Elton, Gruber, Brown and Goetzmann 82
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 11
Chapter 11: Problem 7
Roy's criterion is to minimize Prob(RP < RL). When RL = 3%, Prob(RA < 3%) = 0,
Prob(RB < 3%) = 0, and Prob(RC < 3%) = 0. So, investments A, B, and C are
indistinguishable using Roy's criterion with RL = 3%.
Chapter 11: Problem 8
The geometric mean returns of the investments shown in Problem 6 are:
A
G
R = (1.03)
.4
(1.04)
.3
(1.06)
.1
(1.07)
.1
(1.09)
.1
 1 = .0458 (4.58%)
B
G
R = (1.05)
.1
(1.06)
.2
(1.08)
.1
(1.09)
.2
(1.1)
.4
 1 = .0828 (8.28%)
C
G
R = (1.05)
.1
(1.07)
.1
(1.08)
.2
(1.09)
.2
(1.11)
.4
 1 = .0898 (8.98%).
Thus, C > B > A.
Elton, Gruber, Brown and Goetzmann 83
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 11
Elton, Gruber, Brown and Goetzmann 84
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 11
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 12
Chapter 12: Problem 1
Equation (12.1) in the text can be used to answer this question:
US N
US
F US
N
F N
R R R R
,
µ
o o
×
÷
>
÷
As is explained in the text, if the above inequality holds, then the foreign
investment will be attractive to a U.S. investor.
US
R and
N
R for the foreign
countries are given in the problem's table. From the tables in the text, we have:
oN µN,US
Austria 24.50 0.281
France 17.76 0.534
Japan 25.70 0.348
U.K. 15.59 0.646
Also, from the text tables, oUS = 13.59. Given that RF = 6%, we have:
N
F N
R R
o
÷
US N
US
F US
R R
,
µ
o
×
÷
Austria 0.327 0.289
France 0.563 0.550
Japan 0.311 0.358
U.K. 0.577 0.665
For Austria and France, the above inequality holds, so a U.S. investor should
consider those foreign markets as attractive investments; for Japan and the U.K.,
the above inequality does not hold, so a U.S. investor should not consider those
foreign markets as attractive investments.
Elton, Gruber, Brown and Goetzmann 85
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 12
Chapter 12: Problem 2
To answer this question, use the formula introduced in Chapter 5 for finding the
minimumrisk portfolio of two assets:
12 2 1
2
2
2
1
12 2 1
2
2
1
2 µ o o o o
µ o o o
÷ +
÷
=
GMV
X
where X1 is the investment weight for asset 1 and X2 = 1  X1.
For equities, oUS = 13.59, oN = 16.70 and µN,US = 0.423. So the minimumrisk portfolio is:
( ) ( )( )( )
( ) ( ) ( )( )( )( )
( ) % 34 . 67 6734 . 0
423 . 0 7 . 16 59 . 13 2 7 . 16 59 . 13
423 . 0 7 . 16 59 . 13 7 . 16
2 2
2
=
÷ +
÷
=
GMV
US
X
( ) % 66 . 32 3266 . 0 1 = ÷ =
GMV
US
GMV
N
X X
For bonds, oUS = 7.90, oN = 9.45 and µN,US = 0.527. So the minimumrisk portfolio is:
( ) ( )( )( )
( ) ( ) ( )( )( )( )
( ) % 41 . 68 6841 . 0
527 . 0 45 . 9 9 . 7 2 45 . 9 9 . 7
527 . 0 45 . 9 9 . 7 45 . 9
2 2
2
=
÷ +
÷
=
GMV
US
X
( ) % 59 . 31 3159 . 0 1 = ÷ =
GMV
US
GMV
N
X X
For Tbills, oUS = 0.35, oN = 6.77 and µN,US = ÷0.220. So the minimumrisk portfolio is:
( ) ( )( )( )
( ) ( ) ( )( )( )( )
( ) % 63 . 98 9863 . 0
22 . 0 77 . 6 35 . 0 2 77 . 6 35 . 0
22 . 0 77 . 6 35 . 0 77 . 6
2 2
2
=
÷ ÷ +
÷ ÷
=
GMV
US
X
( ) % 37 . 1 0137 . 0 1 = ÷ =
GMV
US
GMV
N
X X
Elton, Gruber, Brown and Goetzmann 86
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 12
Chapter 12: Problem 3
In the text, the return due to exchangerate changes (RX) is shown to be equal to
fxt/fxt1  1, where fxt is the foreign exchange rate at time t expressed in terms of the
investor's home currency per unit of foreign currency. Let fxt be the exchange rate
expressed in terms of dollars and fx
*
t be the exchange rate expressed in terms of
pounds. These two rates are simply reciprocals, i.e., fx
*
t = 1/fxt. So from the table in
the problem we have:
Period
(1 + RX)
(for US investor)
(1 + R
*
X)
(for UK investor)
1 2.5/3 = 0.833 3/2.5 = 1.200
2 2.5/2.5 = 1.000 2.5/2.5 = 1.000
3 2/2.5 = 0.800 2.5/2 = 1.250
4 1.5/2 = 0.750 2/1.5 = 1.333
5 2.5/1.5 = 1.667 1.5/2.5 = 0.600
The total return to a U.S. investor from a U.K. investment is (1 + RX)(1 + RUK) ÷ 1; the
total return to a U.K. investor from a U.S. investment is(1 + R
*
X)(1 + RUS) ÷ 1. So:
Return to U.S. Investor
Period
From U.S.
Investment From U.K. Investment
1 10% (0.833)(1.05) ÷ 1 = ÷12.5%
2 15% (1)(0.95) ÷ 1 = ÷ 5.0%
3 ÷5% (0.8)(1.15) ÷ 1 = ÷ 8.0%
4 12% (0.75)(1.08) ÷ 1 = ÷19.0%
5 6% (1.667)(1.1) ÷ 1 = 83.3%
Average 7.6% 7.76%
Return to U.K. Investor
Period
From U.K.
Investment From U.S. Investment
1 5% (1.2)(1.1) ÷ 1 = 32.0%
2 ÷5% (1)(1.15) ÷ 1 = 15.0%
3 15% (1.25)(0.95) ÷ 1 = 18.75%
4 8% (1.333)(1.12) ÷ 1 = 49.3%
5 10% (0.6)(1.06) ÷ 1 = ÷36.4%
Average 6.6% 15.73%
Elton, Gruber, Brown and Goetzmann 87
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 12
Chapter 12: Problem 4
Using the data and averages from Problem 3 we have:
For U.S. Investor
( ) ( ) ( ) ( ) ( )
% 95 . 6
5
6 . 7 6 6 . 7 12 6 . 7 5 6 . 7 15 6 . 7 10
2 2 2 2 2
=
÷ + ÷ + ÷ ÷ + ÷ + ÷
=
US
o
( ) ( ) ( ) ( ) ( )
% 06 . 38
5
76 . 7 3 . 83 76 . 7 19 76 . 7 8 76 . 7 5 76 . 7 5 . 12
2 2 2 2 2
=
÷ + ÷ ÷ + ÷ ÷ + ÷ ÷ + ÷ ÷
=
UK
o
For U.K. Investor
( ) ( ) ( ) ( ) ( )
% 65 . 6
5
6 . 6 10 6 . 6 8 6 . 6 15 6 . 6 5 6 . 6 5
2 2 2 2 2
=
÷ + ÷ + ÷ + ÷ ÷ + ÷
=
UK
o
( ) ( ) ( ) ( ) ( )
% 70 . 28
5
73 . 15 4 . 36 73 . 15 3 . 49 73 . 15 75 . 18 73 . 15 15 73 . 15 32
2 2 2 2 2
=
÷ ÷ + ÷ + ÷ + ÷ + ÷
=
US
o
Chapter 12: Problem 5
This problem is essentially the same as Problem 3, except that the exchange rate is
given in indirect (yen/$) terms rather than direct ($/yen) terms. From the table in
the problem we have:
Period
(1 + RX)
(for US investor)
(1 + R
*
X)
(for Japanese investor)
1 200/180 = 1.111 180/200 = 0.900
2 180/190 = 0.947 190/180 = 1.056
3 190/150 = 1.267 150/190 = 0.789
4 150/170 = 0.882 170/150 = 1.133
5 170/180 = 0.944 180/170 = 1.059
Elton, Gruber, Brown and Goetzmann 88
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 12
The total return to a U.S. investor from a Japan investment is (1 + RX)(1 + RJ) ÷ 1; the
total return to a Japanese investor from a U.S. investment is(1 + R
*
X)(1 + RUS) ÷ 1. So:
Return to U.S. Investor
Period
From U.S.
Investment From Japan Investment
1 12% (1.111)(1.18) ÷ 1 = 31.10%
2 15% (0.947)(1.12) ÷ 1 = 6.06%
3 5% (1.267)(1.1) ÷ 1 = 39.37%
4 10% (0.882)(1.12) ÷ 1 = ÷1.22%
5 6% (0.944)(1.07) ÷ 1 = 1.01%
Average 9.6% 15.26%
Return to Japanese Investor
Period
From Japan
Investment From U.S. Investment
1 18% (0.9)(1.12) ÷ 1 = 0.80%
2 12% (1.056)(1.15) ÷ 1 = 21.44%
3 10% (0.789)(1.05) ÷ 1 = ÷17.16%
4 12% (1.133)(1.1) ÷ 1 = 24.63%
5 7% (1.059)(1.06) ÷ 1 = 12.25%
Average 11.8% 8.39%
Chapter 12: Problem 6
The answers to this problem are found in the same way as those to Problem 4.
For the U.S. investor: ǔUS = 3.72%; ǔJ = 16.68%
For the Japanese investor: ǔJ = 3.6%; ǔUS = 15.227%
Elton, Gruber, Brown and Goetzmann 89
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 12
Chapter 12: Problem 7
Use the formula for the sample correlation coefficient µ with five observations:
( )( )
( ) ( )
_ _
_
= =
=
÷ ÷
÷ ÷
=
5
1
5
1
2 2
5
1
t t
J J US US
t
J J US US
R R R R
R R R R
t t
t t
µ
For the U.S. investor, µ = ÷0.251.
For the Japanese investor, µ = ÷0.050.
Elton, Gruber, Brown and Goetzmann 90
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 12
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 13
Chapter 13: Problem 1
The equation for the security market line is:
( )
i F m F i
R R R R  ÷ + =
Thus, from the data in the problem we have:
( ) 5 . 0 6 × ÷ + =
F m F
R R R for asset 1
( ) 5 . 1 12 × ÷ + =
F m F
R R R for asset 2
Solving the above two equations simultaneously, we find RF = 3% and
m
R = 9%.
Using those values, an asset with a beta of 2 would have an expected return of:
3 + (9 ÷ 3) × 2 = 15%
Chapter 13: Problem 2
Given the security market line in this problem, for the two stocks to be fairly priced
their expected returns must be:
( ) 8% 08 . 0 5 . 0 08 . 0 04 . 0 = × + =
X
R
( ) 20% 20 . 0 2 08 . 0 04 . 0 = × + =
Y
R
If the expected return on either stock is higher than its return given above, the
stock is a good buy.
Chapter 13: Problem 3
Given the security market line in this problem, the two funds’ expected returns
would be:
( ) 21.2% 212 . 0 8 . 0 19 . 0 06 . 0 = × + =
A
R
( ) 28.8% 288 . 0 2 . 1 19 . 0 06 . 0 = × + =
B
R
Elton, Gruber, Brown and Goetzmann 91
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 13
Comparing the above returns to the funds’ actual returns, we see that both funds
performed poorly, since their actual returns were below those expected given
their beta risk.
Chapter 13: Problem 4
Given the security market line in this problem, the riskless rate equals 0.04 (4%), the
intercept of the line, and the excess return of the market above the riskless rate
(also called the “market risk premium”) equals 0.10 (10%), the slope of the line.
(The return on the market portfolio must therefore be 0.04 + 0.10 = 0.14, or 14%.)
Chapter 13: Problem 5
The price form of the CAPM’s security market line equation is:
( )
( )
( )
(
¸
(
¸
× × ÷ ÷ =
m
m i
m F m i
F
i
Y
Y Y
P r Y Y
r
P
var
cov 1
where and (
F F
R r + = 1 )
m
m m
m
P
P Y
R
÷
= .
From Problem 4, we have 04 . 0 =
F
R and 14 . 0 =
m
R . Therefore
m
m m
P
P Y ÷
= 14 . 0
which gives
m m
Y P = 14 . 1 .
Substituting these vales into the above security market line equation, we have:
( )
( )
( )
( )
( )
(
¸
(
¸
× × ÷ =
(
¸
(
¸
× × ÷ × ÷ =
m
m i
m i
m
m i
m m i i
Y
Y Y
P Y
Y
Y Y
P P Y P
var
cov
10 . 0
04 . 1
1
var
cov
04 . 1 14 . 1
04 . 1
1
Elton, Gruber, Brown and Goetzmann 92
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 13
Chapter 13: Problem 6
To be rigorous, one should use the four KuhnTucker conditions shown in Appendix
E of Chapter 6. To find the optimum portfolio when short sales are not allowed, we
have, for each asset i, the following KuhnTucker conditions:
0 = +
i
i
U
dX
du
(1)
0 =
i i
U X (2)
(3) 0 >
i
X
(4) 0 >
i
U
We have already seen that, given the assumptions of the standard CAPM, setting
0 =
i
dX
du
gives the equilibrium first order condition for asset i, which is the standard
CAPM’s security market line:
( )
i F m F i
R R R R  ÷ + =
or equivalently
( ) 0 = ÷ ÷ ÷
i F m F i
R R R R 
When short sales are not allowed, KuhnTucker condition (1) implies that:
( ) 0 = + ÷ ÷ ÷
i i F m F i
U R R R R 
But, since all assets are held long in the market portfolio, Xi > 0 for each asset and
therefore, given KuhnTucker condition (2), Ui = 0 for each asset. Thus, the standard
CAPM holds even if short sales are not allowed.
Elton, Gruber, Brown and Goetzmann 93
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 13
Chapter 13: Problem 7
Using the two assets in Problem 1, a portfolio with a beta of 1.2 can be
constructed as follows:
0.5X1 + (1.5)(1 – X1) = 1.2
X1 = 0.3; X2 = 0.7
The return on this combination would be:
0.3(6%) + 0.7(12%) = 10.2%
Asset 3 has a higher expected return than the portfolio of assets 1 and 2, even
though asset 1 and the portfolio have the same beta. Thus, buying asset 3 and
financing it by shorting the portfolio would produce a positive (arbitrage) return of
15% ÷ 10.2% = 4.8% with zero net investment and zero beta risk.
Chapter 13: Problem 8
The security market line is:
( )
i F m F i
R R R R  ÷ + =
Substituting the given values for assets 1 and 2 gives two equations with two
unknowns:
( ) 8 . 0 4 . 9 × ÷ + =
F m F
R R R
( ) 3 . 1 4 . 13 × ÷ + =
F m F
R R R
Solving simultaneously gives:
% 3 =
F
R ; % 11 =
m
R
Chapter 13: Problem 9
Substituting the given betas in the given equation yields:
( ) % 8 . 17 178 . 0
1
= R ; ( ) % 1 . 15 151 . 0
2
= R
Elton, Gruber, Brown and Goetzmann 94
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 13
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 14
Chapter 14: Problem 1
Given the zerobeta security market line in this problem, the return on the zero
beta portfolio equals 0.04 (4%), the intercept of the line, and the excess return of
the market above the zerobeta portfolio’s return (also called the “market risk
premium”) equals 0.10 (10%), the slope of the line. The return on the market
portfolio must therefore be 0.04 + 0.10 = 0.14, or 14%.
Chapter 14: Problem 2
Z
R has the same role in the zerobeta model as RF does in the standard model. So,
referring back to the answer to Problem 5 in Chapter 13, simply replace RF with
Z
R
to obtain:
( )
( )
( )
(
¸
(
¸
× × ÷ ÷ =
m
m i
m Z m i
Z
i
Y
Y Y
P r Y Y
r
P
var
cov 1
where ( )
Z Z
R r + = 1 .
Chapter 14: Problem 3
As is shown in the text, the posttax form of the CAPM’s equilibrium pricing
equation is:
( ) ( ) ( )
F i i F m F m F i
R R R R R R ÷ × + × ÷ × ÷ ÷ + = o t  o t
Rearranging the above equation to isolate oi we have:
( ) ( ) ( )
i i F m F m F i
R R R R R to  o t t + × ÷ × ÷ ÷ + ÷ = 1
Comparing the above general equation to the specific one given in the problem,
we see that ( ) 05 . 0 1 = ÷t
F
R , or
( ) t ÷
=
1
05 . 0
F
R , and that 24 . 0 = t . Therefore:
( )
( ) % 58 . 6 0658 . 0
24 . 0 1
05 . 0
=
÷
=
F
R
Elton, Gruber, Brown and Goetzmann 95
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Chapter 14: Problem 4
Since we are given Z R and only one RF , and since Z R > RF , this situation is where
there is riskless lending at RF and no riskless borrowing. The efficient frontier will
therefore be a ray in expected returnstandard deviation space tangent to the
minimumvariance curve of risky assets and intersecting the expected return axis
at the riskless rate of 3% plus that part of the minimumvariance curve of risky
assets to the right of the tangency point. This is depicted in the graph below,
where the efficient frontier extends along the ray from RF to the tangent portfolio L,
then to the right of L along the curve through the market portfolio M and out
toward infinity (assuming unlimited short sales). Note that, unless all investors in the
economy choose to lend or invest solely in portfolio L, the market portfolio M will
always be on the minimumvariance curve to the right of portfolio L.
Since both M and Z are on the minimumvariance curve, the entire minimum
variance curve of risky assets can be traced out by using combinations (portfolios)
of M and Z. Letting X be the investment weight for the market portfolio, the
expected return on any combination portfolio P of M and Z is:
( ) Z m P R X R X R ÷ + = 1 (1)
Recognizing that M and Z are uncorrelated, the standard deviation of any
combination portfolio P of M and Z is:
( )
2
2
2 2
1
Z m P
X X o o o ÷ + = (2)
Elton, Gruber, Brown and Goetzmann 96
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Substituting the given values for m R and Z R into equation (1) gives:
( )
5 10
1 5 15
+ =
÷ + =
X
X X RP
(3)
Substituting the given values for
m
o and
Z
o into equation (2) gives:
( )
64 128 548
64 128 64 484
8 1 22
2
2 2
2 2 2 2
+ ÷ =
+ ÷ + =
× ÷ + × =
X X
X X X
X X
P
o
(4)
Using equations (3) and (4) and varying X (the fraction invested in the market
portfolio M) gives various coordinates for the minimumvariance curve; some of
them are given below:
X 0 0.2 0.4 0.6 0.8 1.0 1.5 2.0
P R 5 7 9 11 13 15 20 25
P
o 8 7.77 10.02 13.58 17.67 22 33.24 44.72
The zerobeta form of the security market line describes equilibrium beta risk and
expected return relationship for all securities and portfolios (including portfolio L)
except those combination portfolios composed of the riskless asset and tangent
portfolio L along the ray RF  L in the above graph:
( )
i
i
Z m Z i R R R R


10 5 + =
÷ + =
The equilibrium beta risk and expected return relationship for any combination
portfolio C composed of the riskless asset and tangent portfolio L along the ray
RF  L in the above graph is described by the following line:
( )
C
L
F
L
F
C
R R
R R 

×
÷
+ =
Elton, Gruber, Brown and Goetzmann 97
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Combining the two lines yields the following graph:
Chapter 14: Problem 5
If the posttax form of the equilibrium pricing model holds, then:
( ) ( ) ( ) ( )t o  t o
F i i F m F
m
F
i R R R R R R ÷ + ÷ ÷ ÷ + =
If the standard CAPM model holds, then:
( )
i F
m
F
i R R R R  ÷ + =
Assume that the posttax model holds instead of the standard model, and
F m
R = o .
For a stock with ( ) 0 > ÷ t o
F i
R , the institution that uses the posttax model would
correctly believe that the stock has a higher expected return than the stock’s
return expected by the institution using the standard model. Similarly, for a stock
with ( ) 0 < ÷ t o
F i
R , the institution that uses the posttax model would correctly
believe the stock has a lower expected return than the stock’s return expected by
the institution using the standard model.
Elton, Gruber, Brown and Goetzmann 98
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Now consider a specific example using the following data for stocks A and B, the
market portfolio and the riskless asset:
0 . 1 =
A
 ; % 8 =
A
o ; 0 . 1 =
B
 ; % 0 =
B
o ; % 14 = m R ; % 4 =
m
o ; % 4 =
F
R ; 25 . 0 = t
If the posttax model holds, then the institution using that model would correctly
believe that the equilibrium expected returns for the two stocks are:
( ) ( ) ( ) ( )
% 15
1 10 4
25 . 0 4 8 0 . 1 25 . 0 4 4 4 14 4
=
+ + =
× ÷ + × × ÷ ÷ ÷ + = A R
( ) ( ) ( ) ( )
% 13
1 10 4
25 . 0 4 0 0 . 1 25 . 0 4 4 4 14 4
=
÷ + =
× ÷ + × × ÷ ÷ ÷ + = B R
The institution using the standard model would incorrectly believe that the stocks’
equilibrium expected returns are:
( )
% 14 10 4
0 . 1 4 14 4
= + =
× ÷ + = A R
( )
% 14 10 4
0 . 1 4 14 4
= + =
× ÷ + = B R
The institution using the posttax model would tend to buy stock A and sell stock B
short. Of course, residual risk puts a limit to the amount of unbalancing the
institution would do. But by some unbalancing, the institution earns an excess
return.
The institution using the standard model would be indifferent between the two
stocks. However, by buying stock B, the institution loses excess return.
Elton, Gruber, Brown and Goetzmann 99
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Chapter 14: Problem 6
Using Ross’s APT model, we can create an arbitrage portfolio as follows:
(1) 0
0
1= ×
_
i
ARB
i
X
= =
_ i
i
ARB
i ARB
a X a (2)
0 = =
_ i
i
ARB
i ARB
b X b (3)
Since the above portfolio has zero net investment and zero risk with respect to the
given twofactor model, by the force of arbitrage its expected return must also be
zero:
0 = =
_
i
i
ARB
i
ARB R X R (4)
From a theorem of linear algebra, since the above orthogonality conditions (1), (2)
and (3) with respect to the X esult in orthogonality condition (4) with respect to
the
A
i
X
ARB
i
r
RB
, i an be expressed as a linear combination of 1, ai and bi: R c
i i
i b a R
2 1 0
1 ì ì ì + + × = (5)
We can create a zerorisk investment portfolio as follows:
1
0
=
_
i
Z
i
X
= =
_ i
i
Z
i Z
a X a
0 = =
_ i
i
Z
i Z
b X b
Substituting the above equations into equation (5) gives:
0
2 1 0
ì
ì ì ì
=
+ + = =
_ _ _ _ i
i
Z
i i
i
Z
i
i
Z
i
i
i
Z
i
Z b X a X X R X R
Elton, Gruber, Brown and Goetzmann 100
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
We can create a strictly marketrisk investment portfolio as follows:
1
1
=
_
i
M
i
X
= =
_ i
i
M
i M
a X a
0 = =
_ i
i
M
i M
b X b
Substituting the above equations into equation (5) gives:
1 0
2 1 0
ì ì
ì ì ì
+ =
+ + = =
_ _ _ _ i
i
M
i i
i
M
i
i
M
i
i
i
M
i
M b X a X X R X R
or
Z M M R R R ÷ = ÷ =
0 1
ì ì
We can create a strictly interest raterisk investment portfolio as follows:
1
0
=
_
i
C
i
X
= =
_ i
i
C
i C
a X a
1 = =
_ i
i
C
i C
b X b
Substituting the above equations into equation (5) gives:
2 0
2 1 0
ì ì
ì ì ì
+ =
+ + = =
_ _ _ _ i
i
C
i i
i
C
i
i
C
i
i
i
C
i
C b X a X X R X R
or
Z C C R R R ÷ = ÷ =
0 2
ì ì
Substituting the derived values for ì0, ì1 and ì2 into equation (5), we have:
( ) ( )
i
Z C
i
Z M Z i b R R a R R R R × ÷ + × ÷ + =
Elton, Gruber, Brown and Goetzmann 101
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Chapter 14: Problem 7
In the graph below, the efficient frontier with riskless lending but no riskless
borrowing is the ray extending from RF to the tangent portfolio L and then along
the minimumvariance curve through the market portfolio M and out toward
infinity (assuming unlimited short sales). All investors who wish to lend will hold
tangent portfolio L in some combination with the riskless asset, since no other
portfolio offers a higher slope. Furthermore, unless all investors lend or invest solely
in portfolio L, the market portfolio M will be along the minimumvariance curve to
the right of portfolio L, since the market portfolio is a wealthweighted average of
all the efficient riskyasset portfolios held by investors, and no rational investor
would hold a riskyasset portfolio along the curve to the left of L.
The expected return on a zerobeta asset is the intercept of a line tangent to the
market portfolio, and the zerobeta portfolio on the minimumvariance frontier
must be below the global minimum variance portfolio of risky assets by the
geometry of the graph. Furthermore, by the geometry of the graph, since the risk
free lending rate is the intercept of the line tangent to portfolio L, and since L is to
the left of M on the minimumvariance curve, the riskfree lending rate must be
below the expected return on a zerobeta asset.
Elton, Gruber, Brown and Goetzmann 102
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
The zerobeta security market line is the line in the graph below extend from the
expected return on a zerobeta asset through the market portfolio and out toward
infinity (assuming unlimited short sales). The expected returnbeta relationships of
all risky securities riskyasset portfolios (including the market portfolio M and
portfolio L) are described by that line. The other line from the riskfree lending rate
to portfolio L only describes the expected returnbeta relationships of combination
portfolios of the riskfree asset and portfolio L; those combination portfolios are not
described by the zerobeta security market line.
Chapter 14: Problem 8
Assume the same situation as in Problem 5. The investor who believes in the
standard (pretax) CAPM expects a return of 14% on either security. You expect a
return before taxes of 15% on stock A and 13% on stock B. If your tax factor was
below the aggregate tax factor (t lower than 0.25) then you should buy stock B
from the other investor and sell that investor stock A. The fact that this will lead to
higher aftertax cash flows for you is straightforward.
Elton, Gruber, Brown and Goetzmann 103
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Chapter 14: Problem 9
This problem can be answered directly by using the equation developed for non
marketable assets. The equation also holds for deleted assets, with the subscript H
now standing for those assets that were left out:
( )
( ) ( )


.

\

+ ×
+
÷
+ =
H i
m
H
m i
H m
m
H
m
F
m
F
i R R
P
P
R R
R R
P
P
R R
R R cov cov
cov
2
o
The effect of leaving out bonds depends on two factors:
1.) Whether or not the returns on the aggregate of all bonds are negatively or
positively correlated with the returns on the aggregate of all stocks;
2.) The correlation between the returns on a particular stock and the returns on
the aggregate of all bonds.
From the above equation, if returns on stocks and bonds are generally positively
correlated (as empirical evidence shows), then the denominator in the second
term of the equation will tend to lower the expected return on any stock. If the
return on a particular stock is negatively correlated with bonds, that will further
lower the stock’s expected return. However, if the stock is positively correlated with
bonds, this will offset the effect of positive correlation between all stocks and
bonds and may actually result in a higher expected return for the stock.
Elton, Gruber, Brown and Goetzmann 104
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 14
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 15
Chapter 15: Problem 1
That is NOT a valid test of the theory, and the empirical evidence IS consistent with
the theory. If highbeta stocks always gave higher returns, then they would be less
risky than lowbeta stocks. It is precisely because the returns on highbeta stocks
are more risky, and hence sometimes below and sometimes above the returns on
lowbeta stocks, that highbeta stocks have higher expected (and over long
periods of time higher actual) returns.
Chapter 15: Problem 2
Let:
Ai R = the expected percentage change in alcoholism in city i;
G R = the expected percentage change in the price of gold;
P R = the expected percentage change in professors’ salaries.
Then we have:
( )
( )
( )
P
P Ai
G P G Ai
R
R R
R R R R
var
cov
× ÷ + =
The above equation is exactly parallel to the zerobeta CAPM equation, with
expected percentage change in alcoholism in a city playing the role of the
expected return on a security. The analogy between variables is seen from:
( )
( )
( )
m
m i
Z m Z i
R
R R
R R R R
var
cov
× ÷ + =
Therefore, tests exactly parallel to those employed in the text can be used.
Elton, Gruber, Brown and Goetzmann 105
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 15
Chapter 15: Problem 3
Since the equality shown in equation (15.7) in the text only holds for an efficient
portfolio, if the market portfolio is inefficient the equality will not hold and instead
we have:
F
k
km
R R ÷ = ìo
The remaining proof follows the proof shown in the text below equation (15.7), but
with the notequal sign replacing the equal sign in all the remaining equations in
the proof.
Chapter 15: Problem 4
One way to use general equilibrium theory to evaluate a stock portfolio
manager’s performance would be to estimate the equilibrium security market line
using historical time series of returns over a period of time along with the portfolio’s
average return and beta. If, given the portfolio’s beta, the portfolio had an
average return above the equilibrium return predicted by the estimated security
market line, it would indicate superior performance. (This performance measure is
known as “Jensen’s alpha” and is discussed at length in Chapter 24.)
Chapter 15: Problem 5
If the posttax form of the CAPM holds, then the real relationship as a cross
sectional regression model is:
( )
i F i i F
i R R R c o ¸  ¸ ¸ + ÷ + + = ÷
2 1 0
If the standard CAPM security market line is tested, the crosssectional regression
model is:
i i F
i R R c  ¸ ¸ + + = ÷
1 0
If o was uncorrelated with  across securities, then the regression estimates of
¸0 and ¸1 in the standard model would be unaffected. However, empirical
evidence shows that o and  are negatively correlated across securities (high
dividend securities tend to have low betas and lowdividend securities tend to
have high betas) and that o is positively correlated with R across securities, so this
is a classic case of missingvariable bias. The effect of the bias is to raise the
estimate of the intercept (¸0) and lower the estimate of the slope (¸1).
Elton, Gruber, Brown and Goetzmann 106
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 15
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 16
Chapter 16: Problem 1
From the text we know that three points determine a plane. The APT equation for
a plane is:
2 2 1 1 0 i i
i b b R ì ì ì + + =
Assuming that the three portfolios given in the problem are in equilibrium (on the
plane), then their expected returns are determined by:
2 1 0
5 . 0 12 ì ì ì + + = (a)
2 1 0
2 . 0 3 4 . 13 ì ì ì + + = (b)
2 1 0
5 . 0 3 12 ì ì ì ÷ + = (c)
The above set of linear equations can be solved simultaneously for the three
unknown values of ì0, ì1 and ì2. There are many ways to solve a set of
simultaneous linear equations. One method is shown below.
Subtract equation (a) from equation (b):
2 1
3 . 0 2 4 . 1 ì ì ÷ = (d)
Subtract equation (a) from equation (c):
2 1
2 0 ì ì ÷ = (e)
Subtract equation (e) from equation (d):
2
7 . 0 4 . 1 ì = or 2
2
= ì
Substitute 2
2
= ì into equation (d):
6 . 0 2 4 . 1
1
÷ = ì or 1
1
= ì
Substitute 1
1
= ì and 2
2
= ì into equation (a):
1 1 12
0
+ + = ì or 10
0
= ì
Thus, the equation of the equilibrium APT plane is:
2 1
2 10
i i
i b b R + + =
Elton, Gruber, Brown and Goetzmann 107
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
Chapter 16: Problem 2
According to the equilibrium APT plane derived in Problem 1, any security with
b1 = 2 and b2 = 0 should have an equilibrium expected return of 12%:
% 12 0 2 2 10 2 10
2 1
= × + + = + + =
i i
i b b R
Assuming the derived equilibrium APT plane holds, since portfolio D has bD1 = 2 and
bD2 = 0 with an expected return of 10%, the portfolio is not in equilibrium and an
arbitrage opportunity exists.
The first step is to use portfolios in equilibrium to create a replicating equilibrium
investment portfolio, call it portfolio E, that has the same factor loadings (risk) as
portfolio D. Using the equilibrium portfolios A, B and C in Problem 1 and recalling
that an investment portfolio’s weights sum to 1 and that a portfolio’s factor
loadings are weighted averages of the individual factor loadings we have:
( ) ( ) 2 1 3 3 1 1
1 1 1 1 1
= = ÷ ÷ + + = ÷ ÷ + + =
D B A B A C B A B B A A E
b X X X X b X X b X b X b
( ) ( ) 0 1 5 . 0 2 . 0 5 . 0 1
2 2 2 2 2
= = ÷ ÷ ÷ + = ÷ ÷ + + =
D B A B A C B A B B A A E
b X X X X b X X b X b X b
Simplifying the above two equations, we have:
1 2 ÷ = ÷
A
X or
2
1
=
A
X
2
1
7 . 0 = +
B A
X X
Since
2
1
=
A
X , and 0 =
B
X
2
1
1 = ÷ ÷ =
B A C
X X X .
Since portfolio E was constructed from equilibrium portfolios, portfolio E is also on
the equilibrium plane. We have seen above that any security with portfolio E’s
factor loadings has an equilibrium expected return of 12%, and that is the
expected return of portfolio E:
% 12 12
2
1
4 . 13 0 12
2
1
= × + × + × = + + = C
C
B
B
A
A
E R X R X R X R
So now we have two portfolios with exactly the same risk: the target portfolio D
and the equilibrium replicating portfolio E. Since they have the same risk (factor
loadings), we can create an arbitrage portfolio, combining the two portfolios by
going long in one and shorting the other. This will create a selffinancing (zero net
investment) portfolio with zero risk: an arbitrage portfolio.
Elton, Gruber, Brown and Goetzmann 108
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
In equilibrium, an arbitrage portfolio has an expected return of zero, but since
portfolio D is not in equilibrium, neither is the arbitrage portfolio containing D and E,
and an arbitrage profit may be made. We need to short sell either portfolio D or E
and go long in the other. The question is: which portfolio do we short and which do
we go long in? Since both portfolios have the same risk and since portfolio E has a
higher expected return than portfolio D, we want to go long in E and short D; in
other words, we want and . This gives us: 1 =
ARB
E
X 1 ÷ =
ARB
D
X
(zero net investment) 0 1 1 = ÷ = + =
_
ARB
D
ARB
E
i
ARB
i
X X X
But since portfolio E consists of a weighted average of portfolios A, B and C,
is the same thing as 1 =
ARB
E
X
2
1
=
ARB
A
X , and 0 =
ARB
B
X
2
1
=
ARB
C
X , so we have:
0 1
2
1
0
2
1
= ÷ + + = + + + =
_
ARB
D
ARB
C
ARB
B
ARB
A
i
ARB
i
X X X X X (zero net investment)
0
2 1 3
2
1
3 0 1
2
1
1 1 1 1
1 1
=
× ÷ × + × + × =
+ + + =
=
_
D
ARB
D C
ARB
C B
ARB
B A
ARB
A
i
i
ARB
i ARB
b X b X b X b X
b X b
(zero factor 1 risk)
0
0 1 5 . 0
2
1
2 . 0 0 5 . 0
2
1
2 2 2 2
2 2
=
× ÷ × ÷ × + × =
+ + + =
=
_
D
ARB
D C
ARB
C B
ARB
B A
ARB
A
i
i
ARB
i ARB
b X b X b X b X
b X b
(zero factor 2 risk)
% 2
10 1 12
2
1
4 . 13 0 12
2
1
=
× ÷ × + × + × =
+ + + =
=
_
D
ARB
D
C
ARB
C
B
ARB
B
A
ARB
A
i
i
ARB
i
ARB
R X R X R X R X
R X R
(positive arbitrage return)
As arbitrageurs exploit the opportunity by short selling portfolio D, the price of
portfolio D will drop, thereby pushing portfolio D’s expected return up until it
reaches its equilibrium level of 12%, at which point the expected return on the
arbitrage portfolio will equal 0. There is no reason to expect any price effects on
portfolios A, B and C, since the arbitrage with portfolio D can be accomplished
using other assets on the equilibrium APT plane.
Elton, Gruber, Brown and Goetzmann 109
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
Chapter 16: Problem 3
From the text we know that three points determine a plane. The APT equation for
a plane is:
2 2 1 1 0 i i
i b b R ì ì ì + + =
Assuming that the three portfolios given in the problem are in equilibrium (on the
plane), then their expected returns are determined by:
2 1 0
12 ì ì ì + + = (a)
2 1 0
2 5 . 1 13 ì ì ì + + = (b)
2 1 0
3 5 . 0 17 ì ì ì ÷ + = (c)
Solving for the three unknowns in the same way as in Problem 1, we obtain the
following solution to the above set of simultaneous linear equations:
8
0
= ì ; 6
1
= ì ; 2
2
÷ = ì ;
Thus, the equation of the equilibrium APT plane is:
2 1
2 6 8
i i
i b b R ÷ + =
Chapter 16: Problem 4
According to the equilibrium APT plane derived in Problem 3, any security with
b1 = 1 and b2 = 0 should have an equilibrium expected return of 12%:
% 14 0 2 6 8 2 6 8
2 1
= × ÷ + = ÷ + =
i i
i b b R
Assuming the derived equilibrium APT plane holds, since portfolio D has bD1 = 1 and
bD2 = 0 with an expected return of 15%, the portfolio is not in equilibrium and an
arbitrage opportunity exists.
The first step is to use portfolios in equilibrium to create a replicating equilibrium
investment portfolio, call it portfolio E, that has the same factor loadings (risk) as
portfolio D. Using the equilibrium portfolios A, B and C in Problem 3 and recalling
that an investment portfolio’s weights sum to 1 and that a portfolio’s factor
loadings are weighted averages of the individual factor loadings we have:
( ) ( ) 1 1 5 . 0 5 . 1 1 1
1 1 1 1 1
= = ÷ ÷ + + = ÷ ÷ + + =
D B A B A C B A B B A A E
b X X X X b X X b X b X b
( ) ( ) 0 1 3 2 1
2 2 2 2 2
= = ÷ ÷ ÷ + = ÷ ÷ + + =
D B A B A C B A B B A A E
b X X X X b X X b X b X b
Elton, Gruber, Brown and Goetzmann 110
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
Simplifying the above two equations, we have:
2
1 1
= + X X
2
B A
3 5 4 = +
B A
X X
Solving the above two simultaneous equations we have:
3
1
=
A
X ,
3
1
=
B
X
3
1
1 = ÷ ÷ = X X X and
B A C
.
ince portfolio E was constructed from equilibrium portfolios, portfolio E is also on
. We have seen e t any security with portfolio E’s
ctor loadings has an equilibrium expected return of 14%, and that is the
S
the equilibrium plane abov hat
fa
expected return of portfolio E:
% 14 17
3
1 1 1
13 12 = × + × + × = + + = C
C
B
B
A E R X R X R X R
same risk: the target portfolio D
they have the same risk (factor
eate an arbitrag portfolio, combining the two portfolios by
d shorting the ot r. This will create a selffinancing (zero net
vestment) portfolio with zero risk: an arbitrage portfolio. In equilibrium, an
rbitrage portfolio has an expected return of zero, but since portfolio D is not in
e arbitrage portfolio containing D and E, and an arbitrage
rofit may be made.
e question is:
hich portfolio do we short and which do we go long in? Since both portfolios
and since portfolio D has a higher expected return than
ortfolio E, we want to go long in D and short E; in other words, we want
0 (zero net investment)
3 3
A
So now we have two portfolios with exactly the
nd the equilibrium replicating portfolio E. Since a
loadings), we can cr e
going long in one an he
in
a
equilibrium, neither is th
p
We need to short sell either portfolio D or E and go long in the other. Th
w
have the same risk
1 =
ARB
D
X p
and 1 ÷ =
ARB
E
X . This gives us:
ARB
1 1 = ÷ = + =
_
ARB
E
ARB
D i
X X X
i
Elton, Gruber, Brown and Goetzmann 111
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
But since portfolio E consists of a weighted average of portfolios A, B and C,
is the same thing as
3
1
÷ =
ARB
A
X ,
3
1
÷ =
ARB
B
X and
3
1
÷ =
ARB
C
X 1 ÷ =
ARB
E
X , so we have:
0 1
3
1
3
1
3
1
= + ÷ ÷ ÷ = + =
_
ARB
B
ARB
A
i
ARB
i
X X X + +
ARB
D
ARB
C
X X (zero net investment)
0
3 3 3
=
1 1 5 . 0
1
5 . 1
1
1
1
1 1 1
× + × ÷ × ÷ × ÷ =
+ +
D
ARB
D
A
C B
ARB
B
i
b X X X
(zero fact 1 risk)
1 1
=
_ i
ARB
i ARB
b X b
1
+ =
C
RB
A
ARB
A
b b b X
or
0 =
0 1 3
3
1
2
3
1
1
3
1
2 2 2 2
× + × + × ÷ × ÷ =
+ + + =
D
ARB
D C
ARB
C B
ARB
B A
ARB
A
i
b X b X b X b X
(zero fac or 2 risk)
2 2
=
_ i
ARB
i ARB
b X b
t
% 1
15 1 17
1
13
1
12
3
1
× + × ÷ × ÷ × ÷ =
+ + + =
=
_
D
ARB
D
C
ARB
C
B
ARB
B
A
ARB
A
i
i
ARB
i
ARB
R X R X R X R X
R X R
(positive arbitrage return)
3 3
=
bitrage
lio will e expect any price effects on portfolios A,
d C, since t with portfolio D can be accomplished using other
ium APT plane.
Chapter 16: Problem 5
The general Kfactor APT equation for expected return is:
As arbitrageurs exploit the opportunity by buying portfolio D, the price of portfolio
D will rise, thereby pushing portfolio D’s expected return down until it reaches its
equilibrium level of 14%, at which point the expected return on the ar
portfo qual 0. There is no reason to
an he arbitrage B
assets on the equilibr
_
=
+ =
K
k
ik k
i b R
1
0
ì ì
where ì0 is the return on the riskless asset, if it exists.
Elton, Gruber, Brown and Goetzmann 112
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
Given the data in the problem and in Table 16.1 in the text, along with a riskless
, the Sharpe multifa ected n a stock in the
ion industry is:
rate of 8% ctor model for the exp return o
construct
% 034 . 10
59 . 1 1 2 2 . 0 12 . 0 4 . 0 56 . 5 6 24 . 0 2 . 1 36 . 5 8
=
÷ × ÷ × ÷ × ÷ × + × + = i R
The last number, ÷1.59, enters because the stock is a construction stock.
hapter 16: Problem 6
A.
From the text we know that, for a 2factor APT model to be consistent with the
andard CAPM,
C
. Given that ( ) 4 = ÷
F
m R R ( )
j F
m
j
R R
ì
 ì ÷ = st and using results from
Problem 1, we have:
1
4 1
ì
 = or 25 . 0
1
=
ì
 ;
2
4 2
ì
 = or 5 . 0
2
=
ì
 .
B.
From the text we know that
2 2 1 1 ì ì
  
i i i
b b + = . So we have:
5 . 0 5 . 0 5 . 0 25 . 0 1 = × + × =
A

85 . 0 5 . 0 2 . 0 25 . 0 3 = × + × =
B

5 . 0 5 . 0 5 . 0 25 . 0 3 = × ÷ × =
C

C.
ssuming all three portfolios in Problem 1 are in equilibrium, then we can use any A
one of them to find the riskfree rate. For example, using portfolio A gives:
( )
A F
m
f
A R R R R  ÷ + = or ( )
A F
m A
F
R R R R  ÷ ÷ =
Given that ( ) % 4 = ÷ m R R , we have: % 12 = A R , 5 . 0 =
A
 and
F
% 10 5 . 0 4 12 = × ÷ =
F
R
Elton, Gruber, Brown and Goetzmann 113
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
Elton, Gruber, Brown and Goetzmann 114
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 16
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 17
Chapter 17: Problem 1
The simplest trading strategy would be to buy a stock at the opening price on the
day that the “heard on the street” column indicates analysts have reported
positive recommendations and to short sell it if analysts have reported negative
recommendations. Since any stock price effect occurs very shortly after the news
is released, the stock position could be unwound after five days. Naturally, in
examining returns from this strategy, purchases and sales would have to be
adjusted for transactions costs. The results of Davies and Canes suggest that
roundtrip transactions costs must be less than two percent and perhaps less than
one percent for this rule to produce excess returns. In testing this strategy, we
would have to be sure to adjust the returns for risk. Following this strategy will lead
to a changing portfolio of stocks being held over time. Either the beta or standard
deviation of this portfolio could be used as a risk measure.
Chapter 17: Problem 2
See the section in the text entitled “Relative Strength” for the answer to this
question.
Chapter 17: Problem 3
There are several ways this rule could be tested. One way would be to rank all
stocks by their P/E ratios, select the X percent (e.g., 20%) of the stocks with the
lowest P/E ratios, then select from that group the Y percent (e.g., 20%) with the
largest fiveyear growth rates. After then making sure that transactions costs are
included, riskadjusted excess returns for the final group could be obtained and
examined using one of the methodologies outlined in the text.
Chapter 17: Problem 4
If a market is semistrongform efficient, the efficient market hypothesis says that
prices should reflect all publicly available information. If you have access to a
“good” and significant piece of information that you believe is not yet public
information, you could examine the residuals from a model such as the “market
model” to see if there were recently positive excess returns, indicating whether or
not the market had already incorporated that information.
Elton, Gruber, Brown and Goetzmann 114
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 17
Chapter 17: Problem 5
If a market is semistrongform efficient, the efficient market hypothesis says that
prices should reflect all publicly available information. If publicly available
information is already fully reflected in market prices, one would strongly suspect
the market to be weakform efficient as well. The only rational explanation for
weakform inefficiency is if information is incorporated into prices slowly over time,
thus causing returns to be positively autocorrelated. The only exception to this
might be if the market is strongform inefficient and monopoly access to
information disseminates through widening circles of investors over time.
Chapter 17: Problem 6
You could test that by following any of the test methodologies outlined in the text
for semistrongform efficiency, where day zero (the “event day”) is defined as the
day at which the block of stocks becomes available for trading.
Chapter 17: Problem 7
Recall that the zerobeta CAPM leads to lower expected returns for highbeta
(above 1) stocks and higher expected returns for lowbeta stocks than does the
standard CAPM. If we were testing a phenomenon that tended to occur for low
beta stocks and not for highbeta stocks, then the zerobeta CAPM could show
inefficiency while the standard CAPM showed efficiency.
Chapter 17: Problem 8
The betting market at roulette is in general an efficient market. Though betting on
the roulette wheel has a negative expected return, there is no way that that
information can be used to change the expected return. The only exception to
this might be if the roulette wheel was not perfectly balanced. Since the house
does not change the odds (prices) to reflect an unbalanced roulette wheel, an
unbalanced wheel would make the betting market at roulette inefficient.
Chapter 17: Problem 9
As in Problem 6, you could test that by following any of the test methodologies
outlined in the text for semistrongform efficiency, where day zero (the “event
day”) could be defined either as the day of retirement or as the day the
retirement is first announced to the public.
Elton, Gruber, Brown and Goetzmann 115
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 17
Elton, Gruber, Brown and Goetzmann 116
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 17
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 18
Chapter 18: Problem 1
Since the company’s growth rate of 10% extends into the future indefinitely, use
the constantgrowth model to value its stock:
( )
13 . 15 $
10 . 0 14 . 0
1 . 1 55 . 0 1
0 1
0
=
÷
×
=
÷
+
=
÷
=
g k
g D
g k
D
P
Chapter 18: Problem 2
Using equation (18.5b) in the text, we have:
00 . 20 $
5 . 0 14 . 0 12 . 0
1
1
0
=
× ÷
=
÷
=
rb k
D
P
Chapter 18: Problem 3
Solving equation (18.5b) in the text for k (the required rate of return) we have:
( ) % 3 . 10 103 . 0 5 . 0 14 . 0
30
1
0
1
= × + = + = rb
P
D
k
Chapter 18: Problem 4
Solving equation (18.5b) in the text for r (the rate of return on new investment) we
have:
( ) % 7 . 20 207 . 0
5 . 0
1
60
1
12 . 0
1
0
1
= × 
.

\

÷ = ×


.

\

÷ =
b P
D
k r
So the rate of return on new investment would have to change from 14% to 20.7%,
an increase of 6.7 percentage points.
Elton, Gruber, Brown and Goetzmann 117
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 18
Chapter 18: Problem 5
This problem can be solved using the twoperiod growth model shown in the text,
where the first growth period is 5 years with a growth rate of 10% (g1) followed by a
growth rate of 6% (g2) indefinitely:
( )
( ) ( )
( )
( ) ( )
( )
( )
( )
5
2
6
1
5
1
1 0
5
2
6
1
5
1
1
5
2
6
5
1
1
1 1
5
5
5
1
1
1 1
0
1
1
1
1
1
1
1
1
1
1 1
1
1 1
1
k
g k
D
g k
k
g
g D
k
g k
D
g k
k
g
D
k
g k
D
k
g D
k
P
k
g D
P
t
t
t
t
t
t
+


.

\

÷
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
+ =
+


.

\

÷
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
=
+


.

\

÷
+
+
+
=
+
+
+
+
=
_
_
=
÷
=
÷
Recognizing that the dividend at the end of period 6 is equal to the dividend at
the end of period 5 compounded 1 period at g2 and then adjusted by a factor of
0.5/0.3 to reflect the increased dividend payout rate, we have:
( )
( ) ( )
( )
565 . 1 $
3 . 0
5 . 0
06 . 1 1 . 1 55 . 0
3 . 0
5 . 0
1 1
3 . 0
5 . 0
1
5
2
5
1 0
2 5 6
=
× × × =
× + + =
× + =
g g D
g D D
Elton, Gruber, Brown and Goetzmann 118
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 18
So we have:
( )
64 . 12 $
163 . 10 474 . 2
925 . 1
563 . 19
04 . 0
16355 . 0
605 . 0
14 . 1
06 . 0 14 . 0
565 . 1
10 . 0 14 . 0
14 . 1
1 . 1
1
1 . 1 55 . 0
5
5
0
=
+ =
+ × =

.

\

÷
+
(
(
(
(
(
¸
(
¸
÷

.

\

÷
× × = P
Chapter 18: Problem 6
This problem can be solved using the threeperiod growth model shown in the text,
where the first growth period is 5 years with a growth rate of 10% (g1) followed
each year by linearly declining growth rates (g2, g3, g4 and g5) over a second
period of 4 years down to a 6% steadystate growth rate (gs) indefinitely thereafter.
Since the growth rate is declining linearly over the 4year period, the annual
decline is 8 . 0
5
6 10
=
÷
percentage points per year. So we have g1 = 10% (first 5
years), g2 = 9.2% (year 6), g3 = 8.4% (year 7), g4 = 7.6% (year 8), g5 = 6.8% (year 9)
and gS = 6% (year 10 and thereafter), and the model is:
( ) ( )
( )
( ) ( )
( )
( ) ( )
( ) ( )
9
10
9
6
4
2
5
1 0
1
5
1
1 0
9
10
9
6
4
2
5
1
5
1
1
9
9
9
6 1
5
1
1 0
1 1
1 1
1
1
1
1
1 1
1
1
1
1
1 1
1
1
1
k
g k
D
k
g g D
g k
k
g
g D
k
g k
D
k
g D
g k
k
g
D
k
P
k
D
g k
k
g
D P
S
t
t
t
j
j
S
t
t
t
j
j
t
t
t
+


.

\

÷
+
+
+ +
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
+ =
+


.

\

÷
+
+
+
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
=
+
+
+
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
=
_
[
_
[
_
=
÷
=
=
÷
=
=
Elton, Gruber, Brown and Goetzmann 119
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 18
Recognizing that the dividend at the end of period 10 is equal to the dividend at
the end of period 9 compounded 1 period at gS and then adjusted by a factor of
0.5/0.3 to reflect the increased dividend payout rate, we have:
( )
( ) ( ) ( )
( )
129 . 2 $
3 . 0
5 . 0
06 . 1 068 . 1 076 . 1 084 . 1 092 . 1 1 . 1 55 . 0
3 . 0
5 . 0
1 1 1
3 . 0
5 . 0
1
5
5
2
5
1 0
9 10
=
× × × × × × × =
× + × + × + =
× + =
[
=
S
j
j
S
g g g D
g D D
So we have:
( )
( ) ( )
( ) ( )
( )
( )
( )
( )
( )
( )
( )
( )
( )
29 . 12 $
184 . 8 371 . 0 396 . 0 419 . 0 441 . 0 474 . 2
14 . 1
06 . 0 14 . 0
129 . 2
14 . 1
068 . 1 076 . 1 084 . 1 092 . 1 1 . 1 55 . 0
14 . 1
076 . 1 084 . 1 092 . 1 1 . 1 55 . 0
14 . 1
084 . 1 092 . 1 1 . 1 55 . 0
14 . 1
092 . 1 1 . 1 55 . 0
10 . 0 14 . 0
14 . 1
1 . 1
1
1 . 1 55 . 0
1 1
1 1
1
1
1
1
9
9
5
8
5
7
5
6
5
5
9
6
10
9
6
4
2
5
1 0
1
5
1
1 0 0
=
+ + + + + =

.

\

÷
+
× × × × ×
+
× × × ×
+
× × ×
+
× ×
+
(
(
(
(
(
¸
(
¸
÷

.

\

÷
× × =
+


.

\

÷
+
+
+ +
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
+ =
_
[
=
÷
=
k
g k
D
k
g g D
g k
k
g
g D P
t
t
t
j
j
Chapter 18: Problem 7
Solving equation (18.5b) in the text for k (the expected rate of return) we have:
( ) % 1 . 18 181 . 0 5 . 0 14 . 0
9
1
0
1
= × + = + = rb
P
D
k
Elton, Gruber, Brown and Goetzmann 120
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 18
Chapter 18: Problem 8
Since the company’s growth rate of 10% extends into the future indefinitely, use
the equation (18.6) in the text from the constantgrowth model:
( )
( ) % 7 . 16 167 . 0
1 . 0
9
1 . 1 55 . 0
1
0
0
0
1
=
+
×
=
+
+
= + = g
P
g D
g
P
D
k
Chapter 18: Problem 9
This problem can be solved using the twoperiod growth model shown in the text,
where the first growth period is 10 years with a growth rate of rb = g1 followed by a
growth rate of 5% (g2) indefinitely. The model is:
( )
10
2
11
1
10
1
1 0
1
1
1
1
k
g k
D
g k
k
g
D P
+


.

\

÷
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
× =
Given r = 0.14 and b = 0.5, g1 = 0.14 × 0.5 = 0.07 (7%). Also,
( )
( ) (
( )
93 . 1 $
05 . 1 07 . 1 1
1 1
1
9
2
9
1 1
2 10 11
=
× × =
+ + =
+ =
g g D
g D D
)
So we have:
( )
21 . 16 $
88 . 8 33 . 7
12 . 1
05 . 0 12 . 0
93 . 1
07 . 0 12 . 0
12 . 1
07 . 1
1
1
10
10
0
=
+ =

.

\

÷
+
(
(
(
(
(
¸
(
¸
÷

.

\

÷
× = P
Elton, Gruber, Brown and Goetzmann 121
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 18
Chapter 18: Problem 10
This problem can be solved iteratively by substituting various values for k into the
first formula shown in the answer for Problem 9. By trial and error the solution is
k = 9.6%.
Chapter 18: Problem 11
As with Problem 10, this problem can be solved iteratively by substituting various
values for the length of the first growth period into the first formula shown in the
answer for Problem 9. By trial and error the solution is 24 years.
Chapter 18: Problem 12
The solution to this problem is a general form of the model shown in the answer to
Problem 6:
( )
( ) ( )
( )
( )
( )
( )
( ) ( )
2 1
2 1
2 1
1
2
1
1
2 1
1
1
1 1
1
1 1
1
1
1
1
1 1
1
1
1
1
1
1
1 2
1
1 1 0
1
1
1 0
2 1
2 1
1 1
1
1 0 0
N N
S
N N
N N
N t
t
N
j
S
N
N
N N
N N
N N
N t
t
t
N
k
g k
D
k
N
g g
j g g D
g k
k
g
g D
k
P
k
D
g k
k
g
g D P
+
+ +
+
+ =
=
+
+
+
+ =
+


.

\

÷
+





.

\

+


.

\

+
÷
× ÷ + +
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
× + =
+
+


.

\

+
+
(
(
(
(
(
¸
(
¸
÷


.

\

+
+
÷
× + =
_
[
_
where
D0 = the justpaid dividend
g1 = the annual growth rate during the first period of years
N1 = the number of years in the first growth period
N2 = the number of years in the second growth period of linearly changing growth
rates
gS = the annual steadystate growth rate after the second period of linearly
changing growth rates
Note that the step value for linearly changing rates from g1 to gS is
(g1 ÷ gS) / (N2 + 1), not (g1 ÷ gS) / N2.
Elton, Gruber, Brown and Goetzmann 122
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 18
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 19
Chapter 19: Problem 1
If earnings follow a meanreverting process, then it is appropriate to use historical
data to forecast future earnings. There are many appropriate techniques. Three
specific ones are presented below.
A.
If earnings follow a meanreverting process with no trend or cycle, the following
exponential smoothing model could be used to forecast future earnings:
( )
1 1
ˆ ˆ
÷ ÷
÷ + =
t t t t
E E a E E
where
t
E
ˆ
= the timet forecast for earnings at time t + 1;
Et = the actual earnings at time t;
a = a constant less than 1.0.
B.
If earnings follow a meanreverting process with a trend but no cycle, either
smoothed earnings plus the trend or smoothed earnings times the trend could be
used, depending on whether the trend was additive or multiplicative. For example,
with an additive trend the forecast would be:
t t
g E ˆ
ˆ
+
where
( ) ( )  
1 1 1 1
ˆ
ˆ
ˆ
ˆ ˆ
÷ ÷ ÷ ÷
+ ÷ + + =
t t t t t t
g E E a g E E ;
t
gˆ is the timet estimate of the trend.
See footnote 7 in the text for further details on this technique.
C.
If earnings follow a meanreverting process with a trend and a cycle, then the
forecast is smoothed earnings adjusted for the trend and the cycle. For example,
with an additive trend and a multiplicative cycle the forecast would be:
( )
t t t
f g E
ˆ
ˆ
ˆ
× +
where is the timet estimate of the cycle.
t
f
ˆ
Elton, Gruber, Brown and Goetzmann 123
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 19
Chapter 19: Problem 2
If there was a strong relationship between a firm’s earnings and the overall
industry’s and economy’s earnings, then, for example, a linear model could be
estimated:
E I i
cE bE a E + + =
where
Ei = the firm i’s earnings;
EI = the industry’s earnings;
EE = the economy’s earnings.
Such an equation switches the forecasting task from forecasting Ei directly to
forecasting it indirectly by first forecasting EI and EE and estimating the parameters
a, b and c.
Chapter 19: Problem 3
YES. Mean reversion could be present in the industry’s and economy’s earnings,
too.
Chapter 19: Problem 4
YES. The economy could also exhibit independence in earnings changes.
Chapter 19: Problem 5
If earnings expectations are important in determining share prices, then a valuable
analyst is one who can forecast changes in investors’ expectations. If forecasts in
general become more accurate over time, a valuable analyst is one who at any
point in time can forecast more accurately than the average analyst can.
Elton, Gruber, Brown and Goetzmann 124
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 19
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 20
Chapter 20: Problem 1
We can use the cash flows bonds A and B to replicate the cash flows of bond C.
Let YA be the fraction of bond A purchased and YB be the fraction of bond B
purchased. (Note that these are not investment weights that sum to 1.) Then we
have:
t = 1: $100 YA + $80 YB = $90
t = 2: $1,100 YA + $1,080 YB = $1,090
Solving the above two equations simultaneously gives YA= YB = 1/2. So buying 1/2
of bond A and 1/2 of bond B gives the same cash flows as buying 1 bond C (or,
equivalently, buying 1 bond A and 1 bond B gives the same cash flows as buying
2 of bond C). Therefore, if the Law of One Price held, the bonds’ current prices
would be related as follows:
1/2 PA + 1/2 PB = PC
But, since we are given that PA = $970, PB = $936 and PC = $980, we have instead:
1/2 × $970 + 1/2 × $936 = $953 < $980
The Law of One Price does not hold.
Given that the future cash flows of the portfolio of bonds A and B are identical in
timing and amount to those of bond C, and assuming that all three bonds are in
the same risk class, an investor should purchase 1 bond A and 1 bond B rather
than 2 of bond C.
Chapter 20: Problem 2
A.
A bond’s current yield is simply its annual interest payment divided by its current
price, so we have:
Current Yield = $100 ÷ $960 = 0.1042 (10.42%)
Elton, Gruber, Brown and Goetzmann 125
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 20
B.
A bond’s yield to maturity is the discount rate that makes the sum of the present
values of the bond’s future cash flows equal to the bond’s current price. Since this
bond has annual cash flows, we need to find the rate, y, that solves the following
equation:
( ) ( )
5
5
1
1
1000 $
1
100 $
960 $
y y
t
t
+
+


.

\

+
=
_
=
We can find y iteratively by trial and error, but the easiest way is to use a financial
calculator and input the following:
PV = ÷ 960
PMT = 100
FV = 1000
N = 5
After entering the above data, compute I to get I = y = 11.08%.
Chapter 20: Problem 3
In general, the nominally annualized spot rate for period t (S0t) is the yield to
maturity for a tperiod zerocoupon (pure discount) instrument:
t
t
S
F
P

.

\

+
=
2
1
0
0
where P0 is the zero’s current market price, F is the zero’s face (par) value, and t
is the number of semiannual periods left until the zero matures.
The zerocoupon bonds in this problem all have face values equal to $1,000.
Elton, Gruber, Brown and Goetzmann 126
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 20
If semiannual periods are assumed, then bond A is a oneperiod zero, bond B is
a twoperiod (oneyear) zero, bond C is a threeperiod zero, and bond D is a
fourperiod (twoyear) zero.
So we have:
(7.99%) 0799 . 0
2
1
1000
= 855
(8.31%) 0831 . 0
2
1
1000
= 885
(8.51%) 0851 . 0
2
1
1000
= 920
(8.33%) 0833 . 0
2
1
1000
960
04
4
04
03
3
03
02
2
02
01
1
01
= ¬


.

\

+
= ¬


.

\

+
= ¬


.

\

+
= ¬


.

\

+
=
S
S
S
S
S
S
S
S
The nominally annualized implied forward rates (ft,t+j) can be obtained from the
above spot rates. A general expression for the relationship between current spot
rates and implied forward rates is:
2 1
2
1
2
1
1
, 0
, 0
,
×
(
(
(
(
(
(
(
¸
(
¸
÷






.

\



.

\

+


.

\

+
=
+
+
+
j
t
t
j t
j t
j t t
S
S
f
where t is the semiannual period at the end of which the forward rate begins, j is
the number of semiannual periods spanned by the forward rate, and both t and
j are integers greater than 0.
Elton, Gruber, Brown and Goetzmann 127
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 20
We can an obtain a set of oneperiod forward rates by setting j equal to 1 and
varying t from 1 to 3 in the preceding equation:
( )
( )
( )
( )
( )
( )
(7.04%) 0704 . 0 2 1
0416 . 1
0400 . 1
2 1
2
1
2
1
(7.92%) 0792 . 0 2 1
0426 . 1
0416 . 1
2 1
2
1
2
1
(8.70%) 0870 . 0 2 1
0417 . 1
0426 . 1
2 1
2
1
2
1
3
4
3
03
4
04
34
2
3
2
02
3
03
23
1
2
1
01
2
02
12
= ×


.

\

÷ = ×
(
(
(
(
(
¸
(
¸
÷





.

\



.

\

+


.

\

+
=
= ×


.

\

÷ = ×
(
(
(
(
(
¸
(
¸
÷





.

\



.

\

+


.

\

+
=
= ×


.

\

÷ = ×
(
(
(
(
(
¸
(
¸
÷





.

\



.

\

+


.

\

+
=
S
S
f
S
S
f
S
S
f
If instead we wanted the expected spot yield curve one period from now under
the pure expectations theory, we can set t equal to 1 and vary j from 1 to 3 in the
preceding equation:
( )
( )
( )
( )
( )
( )
(7.89%) 0789 . 0 2 1
0417 . 1
0400 . 1
2 1
2
1
2
1
(8.31%) 0831 . 0 2 1
0417 . 1
1.0416
2 1
2
1
2
1
(8.70%) 0870 . 0 2 1
0417 . 1
0426 . 1
2 1
2
1
2
1
3
1
1
4
3
1
1
01
4
04
14
14
2
1
1
3
2
1
1
01
3
03
13
13
1
2
1
01
2
02
12
12
= ×
(
(
(
¸
(
¸
÷


.

\

= ×
(
(
(
(
(
(
(
¸
(
¸
÷





.

\



.

\

+


.

\

+
= =
= ×
(
(
(
¸
(
¸
÷


.

\

= ×
(
(
(
(
(
(
(
¸
(
¸
÷





.

\



.

\

+


.

\

+
= =
= ×


.

\

÷ = ×
(
(
(
(
(
¸
(
¸
÷





.

\



.

\

+


.

\

+
= =
S
S
f S
S
S
f S
S
S
f S
Elton, Gruber, Brown and Goetzmann 128
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 20
Chapter 20: Problem 4
We can use the cash flows bonds A and B to replicate the cash flows of bond C.
Let YA be the fraction of bond A purchased and YB be the fraction of bond B
purchased. Then we have:
t = 1: $80 YA + $1,100 YB = $120
t = 2: $1,080 YA + $0 YB = $1,120
Solving the above two equations simultaneously gives:
297
308
27
28
080 , 1
120 , 1
= = =
A
Y
297
10
700 , 29
000 , 1
700 , 29
27
27
000 , 1
27
700 , 29
27
240 , 2
27
240 , 3
100 , 1
27
28
80 120
= = × =

.

\

÷
=

.

\

× ÷
=
B
Y
So buying 308/297 of bond A and 10/297 of bond B gives the same cash flows as
buying 1 bond C (or, equivalently, buying 308 of bond A and 10 of bond B gives
the same cash flows as buying 297 of bond C). Therefore, if the Law of One Price
held, the bonds’ current prices would be related as follows:
308/297 PA + 10/297 PB = PC
But, since we are given that PA = $982, PB = $880 and PC = $1,010, we have instead:
308/297 × $982 + 10/297 × $880 = $1,048 > $1,010
The Law of One Price does not hold. For the Law of One Price to hold, bond C
would have to sell for $1,048.
Elton, Gruber, Brown and Goetzmann 129
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 20
Chapter 20: Problem 5
If the Law of One Price holds, then the same discount rate (which is a spot rate)
applies for the cash flows in a particular period for all three bonds. Also, in the
presence of taxes, the price of each bond must equal the sum of the present
values of its future aftertax cash flows, where the present values are calculated
using the spot rates.
Each bond’s capital gain or loss is simply its principal (par) value minus its price.
Given that each bond has a par value of $1,000, bond A has a capital gain of
$1,000 ÷ $985 = $15, bond B has a capital gain of $1,000 ÷ $900 = $100, and bond
C has a capital loss of $1,000 ÷ $1,040 = ÷ $40.
Given that the periods shown are annual, that taxes must be paid on capital gains
and can be deducted on capital losses, and that the capital gain or loss tax rate
is onehalf of the ordinary income tax rate, we need to find the discount factors
and ordinary income tax rate that makes the following set of equations hold
simultaneously:
( ) ( ) 985 $ 000 , 1 $
2
15 $ 1 80 $ 1 80 $
4 4 4 2
= × + × × ÷ × ÷ × + × ÷ × d d
T
d T d T
( ) 900 $ 000 , 1 $
2
100 1 100 $
2 2 2
= × + × × ÷ × ÷ × d d
T
d T
( ) ( ) 040 , 1 $ 000 , 1 $
2
40 $ 1 120 $ 1 120 $
4 4 4 2
= × + × × + × ÷ × + × ÷ × d d
T
d T d T
where
T = the ordinary income tax rate;
2
02
2
2
1
1


.

\

+
=
S
d = the twosemiannualperiod (oneyear) discount factor;
4
04
4
2
1
1


.

\

+
=
S
d = the foursemiannualperiod (twoyear) discount factor.
The solution to the above set of simultaneous equations is:
T = 0.3303; d2 = 0.8568; d4 = 0.8934
Elton, Gruber, Brown and Goetzmann 130
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 20
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 21
Chapter 21: Problem 1
The duration formula shown in the text for annual payments can easily be
modified to reflect semiannual payments as follows:
0
1
2
2
1
P
i
t CF
D
T
t
t
t
×





.

\


.

\

+
×
=
_
=
where T is the number of semiannual periods remaining to maturity.
Given P0 = $1,000, semiannual interest payments of $50, a principal of $1,000 paid
at the end of 5 years and a flat yield curve at 10%, we have:
05 . 4
2
1 . 8
1000 2
2
10 . 0
1
10 1000
2
10 . 0
1
50
10
10
1
= =
×

.

\

+
×
+





.

\


.

\

+
×
=
_
= t
t
t
D years.
Chapter 21: Problem 2
The duration formula for annual payments annual payments is:
( )
0
1
1
P
i
t CF
D
T
t
t
t
_
=


.

\

+
×
=
where T is the number of years remaining to maturity.
Elton, Gruber, Brown and Goetzmann 131
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 21
Given P0 = $1,000, annual interest payments of $100, a principal of $1,000 paid at
maturity and a flat yield curve at 10%, we have:
( ) ( )
1000
10 . 0 1
1000
10 . 0 1
100
1
_
=
+
×
+


.

\

+
×
=
T
t
T t
T t
D
where T has values of 10, 8, 5 and 3 years.
Using the above equation, we have:
T D
10 6.76
8 5.87
5 4.17
3 2.74
Chapter 21: Problem 3
Let XA be the portfolio’s investment weight for bond A, XB be the portfolio’s
investment weight for bond B, and, since an investment portfolio’s weights sum
to 1, XC = (1 ÷ XA ÷ XB) be the portfolio’s investment weight for bond C. Given the
individual bonds’ durations, the duration of a portfolio of those bonds is:
DP = 5XA + 10XB + 12(1 ÷ XA ÷ XB)
Setting the portfolio’s duration equal to the target duration of 9, we have:
5XA + 10XB + 12(1 ÷ XA ÷ XB) = 9
Since there is just one equation with two unknowns, there are an infinite number
of solutions (portfolios) that will satisfy the equation. Either XA or XB can be
arbitrarily set and then the remaining weights solved for. Three of the infinite
number of solutions are:
1.) XA = 22/56; XB = 7/56; XC = 27/56
2.) XA = 4/14; XB = 7/14; XC = 3/14
3.) XA = 10/28; XB = 7/28; XC = 11/28
Elton, Gruber, Brown and Goetzmann 132
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 21
Chapter 21: Problem 4
Since in this problem there are three bonds with three sets of cash flows to meet
the three liabilities, we have three equations with three unknowns and therefore
one unique solution. In a more realistic situation, there would be many more
bonds than the number of liabilities (many more unknowns than the number of
equations) and thus there would be an infinite number of solutions. In that case,
the linear programming procedure shown in the text’s Appendix B would be
required to find the leastcost solution.
Let YA be the fraction of A bonds to buy, YB be the fraction of B bonds to buy,
and YC be the fraction of C bonds to buy. (Note that these are not investment
weights that sum to 1.) We want to form a portfolio of these three bonds that
replicates the timing and amounts of the liabilities.
At t = 1: $50 YA + $100 YB + $1,000 YC = $250
At t = 2: $1,050 YA + $100 YB + $0 YC = $500
At t = 3: $0 YA + $1,100 YB + $0 YC = $550
The solution to the above set of simultaneous linear equations is:
YA = 9/21; YB = 1/2; YC = 15/84
Assuming fractional purchases may be made, the cost of the bond portfolio is
then:
YA PA + YB PB + YC PC = 9/21 × $950 + 1/2 × $1,000 + 15/84 × $920 = $1,071.43
Chapter 21: Problem 5
Equation (21.6) in the text is a form of a singleindex model for bonds:
( )
i
m
m
m
i
i
i
e R R
D
D
R R + ÷ ÷ =
If the yield curve is flat at 10%, then the first period’s expected return is 10% for
each of the three bonds. Since the market portfolio is a weighted average of the
three bonds, the market portfolio also has an expected return of 10%. The
duration of the market portfolio is a weighted average of the three bonds’
durations. Since the three bonds are assumed to be of equal value, the value
weighted market portfolio is also an equally weighted portfolio. Therefore, the
duration of the market portfolio is:
Dm = 1/3 × 5 + 1/3 × 10 +1/3 × 12 = 9 years
Elton, Gruber, Brown and Goetzmann 133
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 21
Therefore we have:
( )
i m A
e R R + ÷ × ÷ = % 10
9
5
% 10
( )
i m B
e R R + ÷ × ÷ = % 10
9
10
% 10
( )
i m C
e R R + ÷ × ÷ = % 10
9
12
% 10
We have seen in an earlier chapter that, under the assumptions of the Sharpe
singleindex model, the covariance between the returns on any pair of securities
i and j is:
2
m j i ijj
o   o =
Making the same assumptions as those for the Sharpe singleindex model and
recognizing that
m
i
D
D
÷ in the bond singleindex model (equation (21.6)) is
analogous to i in the Sharpe singleindex model, the covariance between the
returns on any pair of bonds i and j is:
2
m
m
j
m
i
ijj
D
D
D
D
o o × × =
Therefore we have:
2 2
9
10
9
5
m m
m
B
m
A
AB
D
D
D
D
o o o × × = × × =
2 2
9
12
9
5
m m
m
C
m
A
AC
D
D
D
D
o o o × × = × × =
2 2
9
12
9
10
m m
m
C
m
B
BC
D
D
D
D
o o o × × = × × =
Elton, Gruber, Brown and Goetzmann 134
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 21
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 22
Chapter 22: Problem 1
Although selling calls today would generate a positive cash flow for the client now,
the client would lose the potential profit he would make if the stock were to
appreciate in value, because the stock would be called away from the client.
Thus, there is a potential opportunity cost of engaging in that strategy.
Chapter 22: Problem 2
The profit diagram of buying the two puts appears as follows:
Elton, Gruber, Brown and Goetzmann 135
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 22
The profit diagram of buying the call appears as follows:
Combining the two profit diagrams we have:
The thicker line in the above diagram represents the profit from the combination. If
the options finish at the money, where the stock price at their expiration equals
their strike prices of $50, the profit would be ÷ $17 (a $17 loss). For the combination
to have a positive profit, the stock must either be below $41.50 or above $67 on
the day the options expire.
Algebraically, letting the stock price on the expiration date = P, the profit is:
50 $ s P :
Profit = ÷ $17 + 2 × ($50 ÷ P) = $83 ÷ 2P (since only the two put options would be
exercised)
$50 < P:
Profit = ÷ $17 + P ÷ $50 = P ÷ $67 (since only the call option would be exercised)
Elton, Gruber, Brown and Goetzmann 136
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 22
Chapter 22: Problem 3
The profit diagram of writing the two $45 calls appears as follows:
The profit diagram of buying the $40 call appears as follows:
Elton, Gruber, Brown and Goetzmann 137
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 22
Combining the two profit diagrams we have:
The thicker line in the above diagram represents the profit from the combination. If
the $40 call option finishes out of or at the money, where the stock price at its
expiration is below or equal to that option’s strike price of $40, the profit would be
$2, because none of the options would be exercised and therefore the profit is
simply the net profit from buying the $40 call option (÷ $8) and selling the two $45
call options ($10). If the two $45 call options finish at the money, where the stock
price on their expiration equals their strike price of $45, the profit would be $7,
equal to the net profit of $2 from buying and writing the options plus the $5 gain
from exercising the $40 call option. $7 is the maximum profit because, at stock
prices higher than $45, although exercising the $40 call option continues to
contribute a gain, the two $45 call options that were sold will be exercised against
the seller and therefore contribute twice the loss, so the profit declines, reaching
zero at a stock price of $52. (At a stock price of $52, the profit from the $40 call will
be $12 ÷ $8 = $4 and the profit from the two $45 calls will be ÷$14 + $10 = ÷ $4,
giving a total profit of 0.) If the stock price is greater than $52 on the expiration
date, the profit will be negative (a loss).
Algebraically, letting the stock price on the expiration date = P, the profit is:
40 $ s P :
Profit = $2 (since no options would be exercised)
45 $ 40 $ < < P :
Profit = $2 + P ÷ $40 (since only the $40 call option would be exercised)
P s 45 $ :
Profit = $2 + P ÷ $40 ÷ 2 × (P ÷ $45) = $52 ÷ P (since all options would be exercised)
Elton, Gruber, Brown and Goetzmann 138
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 22
Chapter 22: Problem 4
From the text, we know that a is the lowest number of upward moves in the stock
price at which the call takes on a positive value at expiration (finishes in the
money), u is the size of each up movement, d is the size of each down movement
and n is the number of periods remaining to the option’s expiration. Given that the
option’s exercise price (E) is $60 and the current stock price (S0) is $50, we need to
solve for the minimum integer a such that:
( )
E d u S
a a
> × ×
÷ 1
0
So we have:
( )
60 $ 9 . 0 2 . 1 50 $
1
> × ×
÷a a
and the solution is a = 5.
To value the call option, we use the binomial formula:
    P n a B Er P n a B S C
n
, , , ,
0
÷
÷ ' =
where
67 . 0
9 . 0 2 . 1
9 . 0 1 . 1
=
÷
÷
=
÷
÷
=
d u
d r
P
73 . 0 67 . 0
1 . 1
2 . 1
= × = × = ' P
r
u
P
    972 . 0 73 . 0 , 10 , 5 , , = = ' B P n a B
    926 . 0 67 . 0 , 10 , 5 , , = = B P n a B
So we have:
( ) 18 . 27 $ 926 . 0 1 . 1 60 $ 972 . 0 50 $
10
= × × ÷ × =
÷
C
Elton, Gruber, Brown and Goetzmann 139
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 22
Chapter 22: Problem 5
The BlackScholes optionpricing formula for valuing a call option is:
( ) ( )
2 1 0
d N
e
E
d N S C
rt
÷ =
We are given:
S0 = $95; E = $105; t = 2/3 years (8 months); o = 0.60; r = 0.08 (8%)
Solving for d1 and d2 we have:
149 . 0
490 . 0
073 . 0
3
2
60 . 0
3
2
36 . 0
2
1
08 . 0
105
95
ln
2
1
ln
2 0
1
= =
×
× 
.

\

× + + 
.

\

=
× 
.

\

+ +


.

\

=
t
t r
E
S
d
o
o
341 . 0
490 . 0
167 . 0
3
2
60 . 0
3
2
36 . 0
2
1
08 . 0
105
95
ln
2
1
ln
2 0
2
÷ =
÷
=
×
× 
.

\

× ÷ + 
.

\

=
× 
.

\

÷ +


.

\

=
t
t r
E
S
d
o
o
From the normal distribution we have:
( ) ( ) 560 . 0 149 . 0
1
= = N d N
( ) ( ) 367 . 0 341 . 0
2
= ÷ = N d N
So the value of the call option is:
67 . 16 $ 367 . 0
105 $
560 . 0 95 $
3
2
08 . 0
= × ÷ × =
×
e
C
Elton, Gruber, Brown and Goetzmann 140
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 22
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 23
Chapter 23: Problem 1
The noarbitrage condition for stockindex futures appears in the text as:
( )
( ) D PV P
R
F
÷ =
+ 1
Given that F = $200, P = $190, R = 6%, and PV(D) = $4, we have:
186 $ 4 $ 190 $ 68 . 188 $
06 . 1
200 $
= ÷ > =
so the futures are overpriced relative to the underlying index.
Therefore, the arbitrage would involve selling the futures, borrowing the present
value of the futures price and the present value of the dividends at 6% for six
months, using some of the borrowed funds to buy the index today (t = 0), and
keeping the remainder as arbitrage profit. Six months from now (t = 1), receive the
futures price for the index, receive the future value of the dividends, and use the
proceeds to pay off the loan. The cash flows are as follows:
t = 0 t = 1
sell futures 0 $200
borrow $200/(1.06) $188.68 + $4 ÷$192.68(1.06)
plus $4 at 6% for = $192.68 = ÷$204.24
six months
buy index for ÷$190 0
delivery against
futures contract
in six months
receive six months 0 $4(1.06)=$4.24
of dividends and
invest them at 6% ________ _______________
total cash flow $2.68 0
So the arbitrage profit is $2.68 per futures contract. If the present value (at t = 0) of
transactions costs is $2.68 or greater then the arbitrage opportunity is negated.
Elton, Gruber, Brown and Goetzmann 141
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 23
Chapter 23: Problem 2
Yes. Farmers need to be assured that they can sell their crops at harvest time,
regardless of market conditions, so that they can make planting and farm
equipment decisions in advance of the harvest. Even if both farmers and General
Mills believe that the spot price at the expiration of the futures contract will be
higher than the futures contract price (so that the farmers would get more money
selling their crops later on at the spot price than by selling futures), futures
contracts make sense economically to the farmers, since selling futures now
eliminates the uncertainty of selling their crops later.
General Mills needs to ensure a steady supply of wheat for their products
regardless of market conditions, and knowing the price of wheat in advance helps
in making pricing and working capital decisions. So a futures contract makes
economic sense from their point of view as well, even if they share the same
distributional assumptions as the farmers that spot wheat prices will be lower at the
expiration of the futures contract than the futures contract price, since buying
futures now eliminates the uncertainty of the cost and availability of wheat later.
Chapter 23: Problem3
One equation for interest rate parity that appears in the text is:
( ) 1 1 ÷ + =
F D
R
S
F
R
where R
D
is the domestic interest rate, R
F
is the foreign interest rate, F is the
domestic futures price for one unit of foreign currency, and S is the spot exchange
rate expressed as domestic currency per unit foreign currency; i.e., both F and S
are expressed in direct terms. From a U.S. viewpoint, the quotes given in the
problem are in indirect terms, so, if R
D
is the U.S. rate and R
F
is the rate for Japan,
then, from the problem, F = 1/115 and S = 1/120. So solving the above equation for
the U.S. rate gives:
( )
( )
( ) % 52 . 8 0852 . 0
1 04 . 1
115
120
1 04 . 1
120
1
115
1
=
÷ × =
÷ × =
D
R
Elton, Gruber, Brown and Goetzmann 142
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 23
Chapter 23: Problem 4
Assume you match the durations (interest rate sensitivities) of longterm and short
term bond futures by holding them long or short in the necessary proportion.
Assuming a normal yield curve, you believe that longterm rates will fall relative to
shortterm rates. If the market does not share your belief today, and if longterm
rates fall and shortterm rates rise, then the prices of longterm bonds and long
term bond futures will rise and the prices of shortterm bonds and shortterm bond
futures will fall. Therefore, you want to be long in longterm bond futures and short
in shortterm bond futures. If instead the entire yield curve shifted up, shortterm
rates would have to rise more than longterm rates for the spread to narrow, so the
above position would still be profitable. If the entire yield curve shifted down, long
term rates would have to fall more than shortterm rates for the spread to narrow,
so the above position would still be profitable.
Chapter 23: Problem 5
Assuming that a futures market exists for corporate bonds, sell futures contracts to
deliver $100 million of 19year corporates one year from today. In one year, close
out your futures position by delivering your 19year corporate bonds; from your
viewpoint today, your 20year corporates have thus been shortened to 1year
corporates.
A strategy that uses futures that are in fact traded would require selling futures
today on 20year government bonds. In one year, sell your corporate bonds and
use the proceeds to purchase an offsetting futures contract on 19year
government bonds to close out your futures position. The additional risk with this
strategy is basis risk, which is the risk that the prices of government bonds and
government bond futures will not move in exactly the same way as corporate
bonds of the same maturity.
Chapter 23: Problem 6
To lock in today's rates, sell $40 million of 10year government bond futures. If
interest rates rise, the value of the futures will fall, which means a profit for you
since you are short the futures. At the end of three months, when your own bond
issue is floated, close out your futures position by buying an offsetting futures
contract. If interest rates have in fact risen, use the profits from your futures position
to finance the increased interest payments on your bond issue. If interest rates
have fallen, use some of the proceeds from your bond issue to cover your loss from
your futures position. Either way, ignoring basis risk, the effective interest rate on
your bond issue is locked in at today's rates by selling futures.
Elton, Gruber, Brown and Goetzmann 143
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 23
Elton, Gruber, Brown and Goetzmann 144
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 23
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 24
Chapter 24: Problem 1
Using standard deviation as the measure for variability, the rewardtovariability
ratio for a fund is the fund’s excess return (average return over the riskless rate)
divided by the standard deviation of return, i.e., the fund’s Sharpe ratio. E.g., for
fund A we have:
833 . 1
6
3 14
=
÷
=
÷
A
F
A R R
o
See the table in the answers to Problem 5 for the remaining funds’ Sharpe ratios.
Chapter 24: Problem 2
The Treynor ratio is similar to the Sharpe ratio, except the fund’s beta is used in
the denominator instead of the standard deviation. E.g., for fund A we have:
833 . 7
5 . 1
3 14
=
÷
=
÷
A
F
A R R

See the table in the answers to Problem 5 for the remaining funds’ Treynor ratios.
Chapter 24: Problem 3
A fund’s differential return, using standard deviation as the measure of risk, is the
fund’s average return minus the return on a naïve portfolio, consisting of the
market portfolio and the riskless asset, with the same standard deviation of return
as the fund’s. E.g., for fund A we have:
% 1 6
5
3 13
3 14 ÷ = 
.

\

×
÷
+ ÷ =


.

\

×
÷
+ ÷
A
m
F
m
F
A
R R
R R o
o
See the table in the answers to Problem 5 for the remaining funds’ differential
returns based on standard deviation.
Elton, Gruber, Brown and Goetzmann 145
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 24
Chapter 24: Problem 4
A fund’s differential return, using beta as the measure of risk, is the fund’s
average return minus the return on a naïve portfolio, consisting of the market
portfolio and the riskless asset, with the same beta as the fund’s. This measure is
often called “Jensen’s alpha.” E.g., for fund A we have:
( ) ( ) ( ) ( ) % 4 5 . 1 3 13 3 14 ÷ = × ÷ + ÷ = × ÷ + ÷
A F
m
F
A R R R R 
See the table in the answers to Problem 5 for the remaining funds’ Jensen alphas.
Chapter 24: Problem 5
This differential return measure is the same as the one used in Problem 4, except
that the riskless rate is replaced with the average return on a zerobeta asset. E.g.,
for fund A we have:
( ) ( ) ( ) ( ) % 5 . 3 5 . 1 4 13 4 14 ÷ = × ÷ + ÷ = × ÷ + ÷
A
Z m Z A R R R R 
The answers to Problems 1 through 5 for all five funds are as follows:
Fund
Sharpe
Ratio
Treynor
Ratio
Differential
Return
Based On
Standard
Deviation
Differential
Return
Based On
Beta and RF
Differential
Return
Based On
Beta and Z R
A 1.833 7.333 ÷1% ÷4% ÷3.5%
B 2.250 18.000 1% 4% 3.5%
C 1.625 13.000 ÷3% 3% 3.0%
D 1.063 14.000 ÷5% 2% 1.5%
E 1.700 8.500 ÷3% ÷3% ÷2.0%
Elton, Gruber, Brown and Goetzmann 146
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 24
Chapter 24: Problem 6
Looking at the table in the answers to Problem 5, we see that Fund B is ranked
higher than Fund A by their Sharpe ratios. Solving for the average return that
would make Fund B’s Sharpe ratio equal to Fund A’s we have:
833 . 1
4
3
=
÷
=
÷
B
B
f
B R R R
o
or
% 33 . 10 = B R
So, for the ranking to be reversed, Fund B’s average return would have to be
lower than 10.33%.
Elton, Gruber, Brown and Goetzmann 147
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 24
Elton, Gruber, Brown and Goetzmann 148
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 24
Elton, Gruber, Brown and Goetzmann
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions to Text Problems: Chapter 25
Chapter 25: Problem 1
A.
The points on a Predictive Realization Diagram would have the following
coordinates (where Pi = predicted change in earnings and Ri = realized change in
earnings):
Industry/Firm Pi Ri
A1 0.05 0.00
A2 0.05 0.03
A3 0.75 ÷0.25
B4 0.04 0.06
B5 0.05 0.04
B6 0.65 0.20
B7 ÷0.01 ÷0.01
C8 .070 0.40
C9 ÷0.03 ÷0.01
C10 ÷0.02 0.02
While there are only ten points on the Prediction Realization Diagram, certain
tendencies can be detected. It is very clear from the diagram that analysts in this
brokerage firm systematically overestimate earnings. Their forecasts have a strong
upward bias. The second marked tendency is fro the degree of overestimation to
grow as positive increases in earnings become larger. Similarly, there is a slight
(based on one observation) tendency for analysts to overestimate the size of a
decrease in earnings when a decrease takes place. The analysts misestimated the
direction of a change in earnings in only two out of the ten cases.
B.
Recall from the text that, for the computation of mean square forecast error
(MSFE), the results are the same whether we use predicted levels or predicted
changes in earnings. We will do the MSFE analysis using levels and the following
formula:
( )
_
=
÷ =
N
i
i i
A F
N
1
2
1
MSFE
where Fi is the forecasted level of earnings for firm i per share Ai is the actual
earnings per share for firm i.
Elton, Gruber, Brown and Goetzmann 149
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 25
Industry/Firm
Fi Ai
( )
2
i i
A F ÷
A1 $1.10 $1.05 0.0025
A2 $1.37 $1.35 0.0004
A3 $4.25 $3.25 1.0000
B4 $2.10 $2.12 0.0004
B5 $2.13 $2.12 0.0001
B6 $3.25 $2.80 0.2025
B7 $1.06 $1.06 0.0000
C8 $2.70 $2.40 0.0900
C9 $0.52 $0.54 0.0004
C10 $1.16 $1.20 0.0016
Sum 1.2979
Therefore:
1298 . 0
10
2979 . 1
MSFE = =
C.
From the text, we know that the MSFE can be decomposed by level of
aggregation as follows:
( ) ( ) ( )   ( ) ( )  
_ _
= =
÷ ÷ ÷ + ÷ ÷ ÷ + ÷ =
N
i
a
i
a
i
N
i
a a R R P P
N
R R P P
N
R P
1
2
1
2 2
1 1
MSFE
where the first term measures the forecast error due to all analysts misestimating
the average earnings in the economy, the second term measures the error due to
individual analysts misestimating the differential earnings for particular industries
from the average for the economy, and the third term measures the error due to
individual analysts misestimating the differential earnings for particular companies
within an industry from the average for that industry. So we have:
Error due forecasting sector of economy:
( ) ( ) 0306 . 0 048 . 0 223 . 0
2
2
= ÷ = ÷ R P
Elton, Gruber, Brown and Goetzmann 150
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 25
Error due forecasting each industry:
( ) ( )  
( ) ( )  
( ) ( )  
( ) ( )  
( ) 0143 . 0 0271 . 0 0169 . 0 0989 . 0
10
1
048 . 0 1367 . 0 223 . 0 2167 . 0 3
048 . 0 0725 . 0 223 . 0 1825 . 0 4
048 . 0 0733 . 0 223 . 0 2833 . 0 3
10
1 1
2
2
2
1
2
= + + × =




.

\

÷ ÷ ÷ × +
÷ ÷ ÷ × +
÷ ÷ ÷ ÷ ×
× = ÷ ÷ ÷
_
=
N
i
a a R R P P
N
Error due forecasting each firm:
( ) ( )   0849 . 0
1
1
2
= ÷ ÷ ÷
_
=
N
i
a
i
a
i
R R P P
N
Notice that the sum of the three components equals 0.1298, which is the total
MSFE we calculated earlier.
To express each component as a percentage of the total MSFE, simply divide
each component by 0.1298 and multiply by 100:
Percent of forecast error due to forecasting sector of economy = 23.57%
Percent of forecast error due to forecasting each industry = 11.02%
Percent of forecast error due to forecasting each firm = 65.41%
D.
1. MSFE for each analyst:
( ) 3343 . 0 0029 . 1
3
1
3
1
MSFE(A)
3
1
2
= × = ÷ × =
_
= i
i i
R P
MSFE(B) = 0.0508
MSFE(C) = 0.0307
Elton, Gruber, Brown and Goetzmann 151
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 25
2. MSFE decomposition for each analyst:
For analyst A,
Industry Error = ( )
2
A A R P ÷ = 0.1272
Company Error = ( ) ( )  
_
=
÷ ÷ ÷
3
1
2
3
1
i
A
i
A
i
R R P P
= ( ) ( ( )  
_
=
÷ ÷ ÷ ÷
3
1
2
0733 . 0 2833 . 0
3
1
i
i i
R P )
= 0.2071
% Industry Error = 100
3343 . 0
1272 . 0
× = 38.05%
% Company Error = 100
3343 . 0
2071 . 0
× = 61.95%
For analyst B,
Industry Error = ( )
2
0725 . 0 1825 . 0 ÷ = 0.0121
Company Error = ( ) (  
_
=
÷ ÷ ÷
4
1
2
0725 . 0 1825 . 0
4
1
i
i i
R P )
= 0.0387
% Industry Error = 23.8%
% Company Error = 76.2%
For analyst C,
Industry Error = ( )
2
1367 . 0 2167 . 0 ÷ = 0.0064
Company Error = ( ) (  
_
=
÷ ÷ ÷
3
1
2
1367 . 0 2167 . 0
3
1
i
i i
R P )
= 0.0243
% Industry Error = 20.8%
% Company Error = 79.2%
Elton, Gruber, Brown and Goetzmann 152
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 25
E.
The calculations in this part use N, not N ÷ 1, in the denominator for variances.
Error Due To Bias = ( )
2
R P ÷ = = 0.0306 ( )
2
048 . 0 223 . 0 ÷
Error Due To Variance = = ( )
2
R P
o o ÷ ( )
2
1569 . 0 3144 . 0 ÷ = 0.0248
Error Due To Covariance = ( )
R P PR
o o µ ÷ × 1 2 = ( ) 1569 . 0 3144 . 0 2461 . 0 1 2 × × ÷ × = 0.0744
% Error Due To Bias = 100
1298 . 0
0306 . 0
× = 23.57%
% Error Due To Variance = 100
1298 . 0
0248 . 0
× = 19.11%
% Error Due To Covariance = 100
1298 . 0
0744 . 0
× = 57.32%
Elton, Gruber, Brown and Goetzmann 153
Modern Portfolio Theory and Investment Analysis, 6th Edition
Solutions To Text Problems: Chapter 25
B.
Indifference Map
Below is one indifference map. The indifference curves up and to the right indicate greater happiness, since these curves indicate more consumption from both candies. Each curve is negatively sloped, indicating a preference of more to less, and each curve is convex, indicating that the rate of exchange of red hots for rock candies decreases as more and more rock candies are consumed. Note that the exact slopes of the indifference curves in the indifference map will depend an the individual’s utility function and may differ among students.
Chapter 1: Problem 2 A. Opportunity Set
The individual can consume everything at time 2 and nothing at time 1, which, assuming a riskless lending rate of 10%, gives the maximum time2 consumption amount: $20 + $20 u (1 + 0.1) = $42. Instead, the individual can consume everything at time 1 and nothing at time 2, which, assuming a riskless borrowing rate of 10%, gives the maximum time1 consumption amount: $20 + $20 y (1 + 0.1) = $38.18
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions to Text Problems: Chapter 1
2
The individual can also choose any consumption pattern along the line AB (the opportunity set) below.
The opportunity set line can be determined as follows. Consumption at time 2 is equal to the amount of money available in time 2, which is the income earned at time 2, $20, plus the amount earned at time 2 from any money invested at time 1, ($20 C1) u (1 + 0.1): C2 = $20 + ($20 C1) u (1.1) or C2 = $42 1.1C1 which is the equation of a straight line with an intercept of $42 and a slope of 1.1.
B.
Indifference Map We are given that the utility function of the individual is:
U(C1 , C 2 ) 1 C1 C 2
C1C 2 50
A particular indifference curve can be traced by setting U(C1,C2) equal to a constant and then varying C1 and C2. By changing the constant, we can trace out other indifference curves. For example, by setting U(C1,C2) equal to 50 we get: CC 1 C1 C 2 1 2 50 or 50C1 50C 2 C1C 2 2450 50
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions to Text Problems: Chapter 1
3
This indifference curve appears in the graph of the indifference map below as the curve labeled “50” (the lowest curve shown). By setting U(C1,C2) equal to 60, we get the curve labeled “60,” etc.
C.
Solution
The optimum solution is where the opportunity set is tangent to the highest possible indifference curve (the point labeled “E” in the following graph).
This problem is meant to be solved graphically. Below, we show an analytical solution: CC U(C1 , C 2 ) 1 C1 C 2 1 2 50 Substituting the equation of the opportunity set given in part A for C2 in the above equation gives: 42C1 1.1C1 U(C1 , C 2 ) 1 C1 42 1.1C1 50 To maximize the utility function, we take the derivative of U with respect to C1 and set it equal to zero: 42 2.2C1 dU 1 1.1 0 50 50 dC1 which gives C1 = $16.82. Substituting $16.82 for C1 in the equation of the opportunity set given in part A gives C2 = $23.50.
2
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions to Text Problems: Chapter 1
4
Chapter 1: Problem 3 If you consume nothing at time 1 and instead invest all of your time1 income at a riskless rate of 10%, then at time 2 you will be able to consume all of your time2 income plus the proceeds earned from your investment: $5,000 + $5,000 (1.1) = $10,500. If you consume nothing at time 2 and instead borrow at time 1 the present value of your time2 income at a riskless rate of 10%, then at time 1 you will be able to consume all of the borrowed proceeds plus your time1 income: $5,000 + $5,000 y (1.1) = $9,545.45 All other possible optimal consumption patterns of time 1 and time 2 consumption appear on a straight line (the opportunity set) with an intercept of $10,500 and a slope of 1.1: C2 = $5,000 + ($5,000 C1) u (1.1) = $10,500 1.1C1
Chapter 1: Problem 4 If you consume nothing at time 1 and instead invest all of your wealth plus your time1 income at a riskless rate of 5%, then at time 2 you will be able to consume all of your time2 income plus the proceeds earned from your investment: $20,000 + ($20,000 + $50,000)(1.05) = $93,500.
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions to Text Problems: Chapter 1
5
If you consume nothing at time 2 and instead borrow at time 1 the present value of your time2 income at a riskless rate of 5%, then at time 1 you will be able to consume all of the borrowed proceeds plus your time1 income and your wealth: $20,000 + $50,000 + $20,000 y (1.05) = $89,047.62 All other possible optimal consumption patterns of time1 and time2 consumption appear on a straight line (the opportunity set) with an intercept of $93,500 and a slope of 1.05: C2 = $20,000 + ($20,000 + $50,000 C1) u (1.1) = $93,500 1.05C1
Chapter 1: Problem 5 With Job 1 you can consume $30 + $50 (1.05) = $82.50 at time 2 and nothing at time 1, $50 + $30 y (1.05) = $78.60 at time 1 and nothing at time 2, or any consumption pattern of time 1 and time 2 consumption shown along the line AB: C2 = $82.50 1.05C1. With Job 2 you can consume $40 + $40 (1.05) = $82.00 at time 2 and nothing at time 1, $40 + $40 y (1.05) = $78.10 at time 1 and nothing at time 2, or any consumption pattern of time 1 and time 2 consumption shown along the line CD: C2 = $82.00 1.05C1.
The individual should select Job 1, since the opportunity set associated with it (line AB) dominates the opportunity set of Job 2 (line CD).
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions to Text Problems: Chapter 1
6
the individual is lending (consuming less at time 1 than the income earned at time 1). along either line below point E.000 C1) u (1.Chapter 1: Problem 6 With an interest rate of 10% and income at both time 1 and time 2 of $5.2) = $11.000 and C1 = time1 income = $5. Along either line above point E. Since the individual can only lend at 10% and must borrow at 20%. 1 C1 100 C1 .1) = $10. this is simply a plot of the function C 2 50 C1 .1C1 With an interest rate of 20% and income at both time 1 and time 2 of $5.000 1. the opportunity set is given by the line CD: C2 = $5. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.000). Chapter 1: Problem 7 For P = 50. the opportunity set is given by the line AB: C2 = $5. this is simply a plot of the function C 2 For P = 100. Gruber. the individual is borrowing (consuming more at time 1 than the income earned at time 1).000 + ($5. the individual’s opportunity set is given by line segments AE and ED.000 + ($5.000. 1 C1 Elton.500 1.000. 6th Edition Solutions to Text Problems: Chapter 1 7 .2C1 Lines AB and CD intersect at point E (where C2 = time2 income = $5.000 C1) u (1.
Chapter 1: Problem 8 This problem is analogous to Problem 2. The problem could be solved graphically. Elton. as in Problem 2. the opportunity set is C2 = $10. the more pizza slices you need to give up one more burger without changing your level of satisfaction). which is the equation for a straight line with an intercept of 5 and a slope of 1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.1C1. Gruber. and you will be better off on an indifference curve to the right of another indifference curve.1 $10. your opportunity set is given algebraically by $2X + $2.50Y = $10 Solving the above equation for X gives X = 5 1.50 each. and let Y = the number of hamburgers.500 1. Substituting this equation into the preference function P = C1 + C2 + C1 C2 yields: 2 P C1 $10.1C1 $10. your indifference curves will be negatively sloped.250. and you have $10.772. hamburgers are $2. your indifference curves will also be convex. Assuming diminishing marginal rate of substitution between pizza slices and hamburgers (the lower the number of hamburgers you have. From Problem 3.500 2.68 C2 = $5.500C1 1.25. 6th Edition Solutions to Text Problems: Chapter 1 8 .2C1 0 dC1 C1 = $4.05 Chapter 1: Problem 9 Let X = the number of pizza slices.500 1.25Y. if pizza slices are $2 each. Then. We present the analytical solution below.1C1 dP 1 1. Graphically. the opportunity set appears as follows: Assuming you like both pizza and hamburgers.
50 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Elton. then C1 will be $97. Graphically. If C2 is 0. the opportunity set is thus C2 = 50 + (50 . you are constrained by your $10 budget to be on an indifference curve that is on or to the left of the opportunity set.50. 6th Edition Solutions to Text Problems: Chapter 1 9 .C1)(1. Algebraically.05) from your investment. your optimal choice is the combination of pizza slices and hamburgers that is represented by the point where your indifference curve is just tangent to the opportunity set (point A below). the opportunity set appears below.05) = 102.A typical family of indifference curves appears below. Therefore. Chapter 1: Problem 10 If you consume C1 at time 1 and invest (lend) the rest of your time1 income at 5%. then from the above equation C2 will be $102. your time2 consumption (C2) will be $50 from your time2 income plus ($50 C1)(1. Although you would rather be on an indifference curve as far to the right as possible. along with a typical family of indifference curves.05C1 If C1 is 0 (no time1 consumption).1.62.
If the borrowing rate is 10% and your time2 income is $100. From the above equation.000 . Solving the above equation for C1 when C2 is 0 gives C1 = $26.1.C1)(1. the future value (in period 2) of your period 1 income will be $100(1. So the maximum you can consume at time 2 is $105 + $100 = $205. Gruber.1.05) = 205 1.000 when C1 is 0.05) = $105. So the maximum you can consume at time 1 is $90.20) from your investment. Chapter 1: Problem 12 If you consume nothing at time 2.C2/1. You can borrow this amount and spend it along with your time.05C1. Similarly.1C1 Elton.1. which is the maximum that can be consumed at time 2.91 + $100 = $190.666.000 + $10. which is the maximum that can be consumed at time 1.or.2C1 If C2 is 0 (no time2 consumption).C1)(1. then the present value (at time 1) of your time2 income is $100/(1.91.Chapter 1: Problem 11 If you consume C1 at time 1 and invest (lend) the rest of your time1 income at 20%.000 from your inheritance plus ($10.000 . 6th Edition Solutions to Text Problems: Chapter 1 10 .1) = 190. C2 = 210 . If you only consume some of your time2 income at time 2 and borrow the present value of the rest at 10% for consumption at time 1. C2 will be $32. then you can borrow the present value of your time2 income for consumption at time 1.000 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.000 + ($10. you have the following opportunity set: C2 = 100 + (100 . With two different interest rates. then you can invest all of your time1 income at 20% and spend the future value of your time1 income plus your time2 income and inheritance on time2 consumption. we have two separate equations for opportunity sets: one for borrowers and one for lenders. You can then spend that amount along with your time 2 income of $100 on time2 consumption. The opportunity set is thus C2 = $10. then you can borrow the present value of your time2 income and your time2 inheritance and spend that amount along with your time1 income on time1 consumption.20) = $32. If you consume nothing at time 1 and instead invest all of your time1 income of $100 at the lending rate of 5%.C2)/(1. your opportunity set is: C1 = 100 + (100 .67. If you only consume some of your time 1 income at time 1 and invest the rest at 5%.000 from your time2 income plus $10. solving the equation for C2. your time2 consumption (C2) will be $10.91. if C1 is 0 (no time1 consumption).91 .1) = $90.C1)(1.income of $100 on time1 consumption.
6th Edition Solutions to Text Problems: Chapter 1 11 . line segment ED represents your opportunity set if you choose to borrow. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. moving along the lines below point E represents borrowing (spending more than your time1 income on time1 consumption). Moving along the lines above point E represents lending (investing some time1 income). line segment AE represents your opportunity set if you choose to lend.Graphically. So your total opportunity set is represented by AED. the two lines appear as follows: The lines intersect at point E (which represents your income endowment for times 1 and 2). Gruber. Since you can only lend at 5%. Elton. Since you must borrow at 10%.
Elton. 6th Edition Solutions to Text Problems: Chapter 1 12 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.
24%.41 Elton.71/2 = 3. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. V 3 = 181/2 = 4. Expected return of Asset 1 = R1 16% u 0.41%.25 + 12% u 0.25 = 12% R 2 = 6%. Standard deviation of Asset 1 = V 1 = [(16% 12%)2 u 0.Elton. Expected return is the sum of each outcome times its associated probability. Covariance of return between Assets 1 and 2 = V 12 = (16 12) u (4 6) u 0.7 Correlation of return between Assets 1 and 2 = U 12 The correlation matrix for all pairs of assets is: 1 1 2 3 4 1 1 1 0 2 1 1 1 0 3 1 1 1 0 4 0 0 0 1 4 1.25]1/2 = 81/2 = 2.27% B. 2.25 + (12 12) u (6 6) u 0. Gruber. 6th Edition Solutions To Text Problems: Chapter 4 13 . R3 = 14%.5 + (8% 12%)2 u 0. V 4 = 10.25 + (12% 12%)2 u 0.5 + 8% u 0.83 u 1.5 + (8 12) u (8 6) u 0.83% V 2 = 21/2 = 1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.25 =4 The variance/covariance matrix for all pairs of assets is: 1 1 2 3 4 8 4 12 0 2 4 2 6 0 3 12 6 18 0 4 0 0 0 10. R4 = 12% Standard deviation of return is the square root of the sum of the squares of each outcome minus the mean times the associated probability. 6th Edition Solutions to Text Problems: Chapter 4 Chapter 4: Problem 1 A.
7 + 2 u 1/4 u 1/4 u ( 4) + 2 u 1/4 u 1/4 u 12 + 2 u 1/4 u 1/4 u 0 + 2 u 1/4 u 1/4 u ( 6) + 2 u 1/4 u 1/4 u 0 + 2 u 1/4 u 1/4 u 0 = 2.6 2 7 (1/3)2 u 8 + (1/3)2 u 2 + (1/3)2 u 18 + 2 u 1/3 u 1/3 u ( 4) + 2 u 1/3 u 1/3 u 12 + 2 u 1/3 u 1/3 u ( 6) = 3.67% 12. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.7 (1/4)2 u 8 + (1/4)2 u 2 + (1/4)2 u 18 + (1/4)2 u 10. 6th Edition Solutions To Text Problems: Chapter 4 14 . Portfolio A B C D E F G H I Expected Return 1/2 u 12% + 1/2 u 6% = 9% 13% 12% 10% 13% 1/3 u 12% + 1/3 u 6% + 1/3 u 14% = 10.5 12. Gruber.C.67% 1/4 u 12% + 1/4 u 6% + 1/4 u 14% + 1/4 u 12% = 11% Portfolio A B C D E F Variance (1/2)2 u 8 + (1/2)2 u 2 + 2 u 1/2 u 1/2 u ( 4) = 0.67% 12.5 4.6 2 6.7 G H I Elton.
5% 1. Sample Average (Mean) Monthly Returns RA 3.4% 5 6.2% 2.5% 1.7% 2 0.2% 3.4% 6 2.5% 1.7% 0.4% 3.9% 10.1% . Monthly Returns Month 3 4 6.4% 6.9% B.4% 6.8% 4.Chapter 4: Problem 2 A.4% 14.1% 1.0% Security A B C 1 3.4% 16.5% 0.4% 10.9% 1.7% 1.
92% C. 6 1.95% 7.7% 1. Sample Standard Deviations of Monthly Returns VA 3.22% .22% RB RC 2.
2 0.22% .4% 1.
22% .2 6.5% 1.
2 1.22% .4% 1.
2% 1.22% .2 6.
1% 1.22% .2 2.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.78% Elton.8% VC 46.2 6 15.92% VB 14.02 6.42 3. 6th Edition Solutions To Text Problems: Chapter 4 15 . Gruber.34 3.
D.22% .7% 1. Sample Covariances and Correlation Coefficients of Monthly Returns V AB ª3.
95% . u 10.5% 2.
4% 1.22% . 0.
95% . u 0.5% 2.
22% .5% 1. 6.
95% . u 3.7% 2.
º « » ¬ 1.4% 1.22% .
95% .0% 2. u 1.
6.22% .2% 1.
95% .4% 2. u 3.
2.22% .1% 1.
u 1.95% .4% 2.
¼ 6 2. X2= 1/2.27 .92 u 3.24 .22% 1/ 2 u 2.15 0.95% 0 u 7.8 0.17 3. U BC 0.09% V P1 1/ 2. X3= 0): RP1 1/ 2 u 1.92% 2. V BC 19.77 E. Portfolio Returns and Standard Deviations Portfolio 1 (X1 = 1/2.89 U AB U AC 2.17 V AC 7.
34 1/ 2 .2 u 15.
24 1/ 2 u 0 u 19.17 1/ 2 u 0 u 7.42 02 u 46.89.02 2 u 1/ 2 u 1/ 2 u 2.2 u 14.
X3= 1/2): RP 2 4. X3= 1/2): RP 3 5. 8. 6th Edition Solutions To Text Problems: Chapter 4 16 . X3= 1/3): RP 4 4.09 2.92% Portfolio 2 (X1 = 1/2.57% 18.53 2.44% V P3 5.96 4. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. X2= 1/3.03% 6.17 2. X2= 1/2.35% V P2 Portfolio 3 (X1 = 0.27% Portfolio 4 (X1 = 1/3.47% V P4 Elton. X2= 0.
8 that a formula for the variance of an equally weighted portfolio (where Xi = 1/N for i = 1.Chapter 4: Problem 3 It is shown in the text below Table 4. …. N securities) is 2 2 V P = 1/N V j V kj V kj .
which in Problem 3 is given as 10. and N is the number of securities. Using the above formula with V 2 = 50 and V kj = 10 we have: j Portfolio Size (N) 5 10 20 50 100 VP 18 14 12 2 10. as the number of securities (N) approaches infinity. V kj is the average j covariance across all pairs of securities.4 Chapter 4: Problem 4 As is shown in the text. Setting the formula shown in the above answer to Problem 3 equal to 11 and using V 2 = 50 and V kj = 10 we have: j 2 V P 1/ N u 50 10 .8 10. 10% above the minimum risk level would result in the portfolio’s variance being equal to 11. where V 2 is the average variance across all securities. an equally weighted portfolio’s variance (total risk) approaches a minimum equal to the average covariance of the pairs of securities in the portfolio. Therefore.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Elton. 10 11 Solving the above equation for N gives N = 40 securities. Gruber. 6th Edition Solutions To Text Problems: Chapter 4 17 .
If the average variance of a single security.2 u 50 10 for Belgian securities.4V i2 0.4V i2 0.4V i2 1. V 2 . If j instead an equally weighted portfolio contains a very large number of securities.6 (60%) for Italian securities and 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Using the formula shown in the preceding answer to Problem 3 with V 2 = 50 and j either V kj = 20 for Italy or V kj = 10 for Belgium we have: Portfolio Size (N securities) 5 20 100 2 Italian V P 2 Belgian V P 26 21. in each country equals 50.4V i2 for Italian securities and V kj 0. if the portfolio contains only one security. the above ratio is equal to 0. Therefore.5 for Italian securities and V i2 0.3 18 12 10. then its variance will be approximately equal to the average covariance of the pairs of securities in the portfolio.2V i2 0.2V i2 0. then j V kj 0. V kj . the fraction of risk that of an individual security that can be eliminated by holding a large portfolio is expressed by the following ratio: V i2 V kj V i2 From Table 4.9.4 Elton. 6th Edition Solutions To Text Problems: Chapter 4 18 .2V i2 4 for Belgian securities. then the portfolio’s average variance is equal to the average variance across all securities.5 20. Setting the above ratio equal to those values and solving for V kj gives V kj securities.4 u 50 20 for Italian securities and V kj 0. V 2 . Gruber. 0.2V i2 for Belgian Thus.Chapter 4: Problem 5 As shown in the text.8 (80%) for Belgian securities. the ratio V i2 V kj V kj equals V i2 0.
8 in the text is 2 2 V P = 1/N V j V kj V kj .Chapter 4: Problem 6 The formula for an equally weighted portfolio's variance that appears below Table 4.
so 42 is the minimum number of securities that will provide a portfolio variance less than 8. and N is the number of securities.8 states that the average variance for the securities in that table was 46. Elton. Gruber. V kj is the average j covariance across all securities.942N = 39.058 .058.058) + 7. holding 42 securities will provide a variance less than 8. Using the above equation 2 with those two numbers. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. and solving for N gives: 8 = 1/N (46. 6th Edition Solutions To Text Problems: Chapter 4 19 . The text below Table 4.561 N = 41. Since the portfolio's variance decreases as N increases.997. where V 2 is the average variance across all securities.7.619 .619 and that the average covariance was 7. setting V P equal to 8.
Elton. 6th Edition Solutions To Text Problems: Chapter 4 20 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
Elton.4 are integrated with the answers to parts A. Elton.24% V 14 = 0 U 14 = 0 V24 = 10.1 We want to find the weights. 6th Edition Solutions To Text Problems: Chapter 5 21 . Short Selling Not Allowed (Note that the answers to part A.27% V 23 = 6 U 23 = 1.7 V 4 = 3.0 V 24 = 0 U 24 = 0 V 34 = 0 U 34 = 0 In this problem. the standard deviation and the expected return of the minimumrisk porfolio.3 below. Gruber. 6th Edition Solutions to Text Problems: Chapter 5 Chapter 5: Problem 1 From Problem 1 of Chapter 4. we know that: R 1 = 12% R 2 = 6% R 3 = 14% R 4 = 12% V21 = 8 V 1 = 2. we will examine 2asset portfolios consisting of the following pairs of securities: Pair A B C D E F Securities 1 and 2 1 and 3 1 and 4 2 and 3 2 and 4 3 and 4 A.) A. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.83% V 12 = 4 U 12 = 1 V22 = 2 V 2 = 1. A.41% V 13 = 12 U 13 = 1 V23 = 18 V 3 = 4. of a pair of assets when short sales are not allowed.2 and A. also known as the global minimum variance (GMV) portfolio. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.1.
67%) 3 This in turn gives the following for the GMV portfolio of Pair A: R GMV 2 1 2 u 12% u 6% 3 3 2 8% 2 V GMV § 1 ·§ 2 · §2· § 1· ¨ ¸ 8 .33%) 3 GMV X2 GMV 1 X1 2 (or 66.We further know that the compostion of the GMV portfolio of any two assets i and j is: X iGMV V j2 V ij V i2 V j2 2V ij 1 X iGMV X GMV j Pair A (assets 1 and 2): Applying the above GMV weight formula to Pair A yields the following weights: GMV X1 2 V 2 V 12 2 V 12 V 2 2V 12 2 (4) 8 2 (2)(4) 1 1 3 6 18 1 (or 33.
¨ ¸ 2 .
2 .
¨ ¸¨ ¸ 4 .
because the correlation between assets 1 and 3 is +1. as is the case in this part of Problem 1. 6th Edition Solutions To Text Problems: Chapter 5 . and the lowest value that can be obtained is the risk of asset 1. This is obvious since. © 3 ¹© 3 ¹ ©3¹ ©3¹ 0 V GMV 0 Recalling that U 12 = 1. the above result demonstrates the fact that. Pair B (assets 1 and 3): Applying the above GMV weight formula to Pair B yields the following weights: GMV X1 GMV 3 (300%) and X 3 2 (200%) This means that the GMV portfolio of assets 1 and 3 involves short selling asset 3. 22 Elton.0. Gruber. then the GMV “portfolio” involves placing all of your funds in the lower risk security (asset 1) and none in the higher risk security (asset 3). Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. portfolio risk is simply a linear combination of the risks of the two assets. But if short sales are not allowed. when two assets are perfectly negatively correlated. the minimumrisk portfolio of those two assets will have zero risk.
j = 4) D (i = 2.428 0.8425 0.95% 12.59% A.75 0. j = 3) E (i = 2.1575 0.14% 0% 1. when short sales are not allowed.75% 2. we have for Pair B: GMV X1 GMV 1 (100%) and X 3 0 (0%) R GMV R1 2 12% .3728 0. Gruber. the graph of all possible combinations (portfolios) of the securities (the portfolio possibilties curves) and the efficient set of those portfolios appear as follows when short sales are not allowed: Pair A The efficient set is the positively sloped line segment. V GMV V1 2.25 0.Thus. 6th Edition Solutions To Text Problems: Chapter 5 23 .572 0. j = 4) 0. j = 4) F (i = 3.83% For the GMV portfolios of the remaining pairs above we have: X iGMV X GMV R GMV V GMV Pair j C (i = 1.3% 2. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. V GMV V 12 8 .2 and A.6272 12% 8% 6.3 For each of the above pairs of securities. Elton.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 5 24 .Pair B The entire line is the efficient set. Pair C Only the GMV portfolio is efficient. Elton. Gruber.
Elton.Pair D The efficient set is the positively sloped line segment. Pair E The efficient set is the positively sloped part of the curve. 6th Edition Solutions To Text Problems: Chapter 5 25 . Gruber. starting at the GMV portfolio and ending at security 4. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
B. In the noshortsales case in Part A. Short Selling Not Allowed (Note that the answers to part B. However.3 below.4 are integrated with the answers to parts B.) B.2 and B.1. starting at the GMV portfolio and ending at security 3. the GMV “portfolio” for Pair B was the lower risk asset 1 alone.Pair F The efficient set is the positively sloped part of the curve. B.1 When short selling is allowed.1. applying the GMV weight formula to Pair B yielded the following weights: GMV GMV X1 2 (200%) 3 (300%) and X 3 This means that the GMV portfolio of assets 1 and 3 involves short selling asset 3 in an amount equal to twice the investor’s original wealth and then placing the original wealth plus the proceeds from the short sale into asset 1.1 above are the same except the one for Pair B (assets 1 and 3). all of the GMV portfolios shown in Part A. This yields the following for Pair B when short sales are allowed: R GMV 3 u 12% 2 u 14% 8% 2 V GMV 3.
2 8.
2.
2 18.
2.
3.
2.
12.
the GMV portfolio of those two assets will have zero risk. Elton. V GMV 0 0 Recalling that U 13 = +1. when two assets are perfectly positively correlated and short sales are allowed. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 5 26 . this demonstrates the fact that.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.2 and B.3 When short selling is allowed. Pair A The efficient set is the positively sloped line segment through security 1 and out toward infinity. Elton. Pair B The entire line out toward infinity is the efficient set.B. Gruber. 6th Edition Solutions To Text Problems: Chapter 5 27 . the portfolio possibilities graphs are extended.
Pair C Only the GMV portfolio is efficient. Gruber. Pair D The efficient set is the positively sloped line segment through security 3 and out toward infinity. Elton. 6th Edition Solutions To Text Problems: Chapter 5 28 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
starting at the GMV portfolio and extending past security 3 toward infinity. Gruber. starting at the GMV portfolio and extending past security 4 toward infinity. Pair F The efficient set is the positively sloped part of the curve. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 5 29 .Pair E The efficient set is the positively sloped part of the curve. Elton.
The tangent portfolio has an expected return of 9. the answer is identical to that above for Pair A. (The particular portfolio held would be on the efficient frontier and would depend on the investor’s degree of risk aversion. With riskless lending and borrowing at either 5% or 8%.95%. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.) Pair B (assets 1 and 3): Since short sales are allowed in Part C and since we saw in Part B that when short sales are allowed the GMV portfolio of assets 1 and 3 has an expected return of 8% and a risk of 0%. the new efficient frontier (efficient set) will be a straight line extending from the vertical axis at the riskless rate. the analytical solution to this problem is presented in the subsequent chapter (Chapter 6). Pair E (assets 2 and 4): We arrived at the following answer graphically. then. Pair C (assets 1 and 4): We have seen that. one would borrow an infinite amount of money at 5% and place it in the GMV portfolio. and then out to infinity. Pair D (assets 2 and 3): Since assets 2 and 3 are perfectly negatively correlated and have a GMV portfolio with an expected return of 8% and a risk of 0%. regardless of the availability of short sales.4% and a standard deviation of 1. if riskless borrowing and lending at 5% existed. the point of tangency occurs at infinity. This would be pure arbitrage (zero risk. the new efficient frontier (efficient set) will be a straight line extending from the vertical axis at the riskless rate and through the GMV portfolio and out to infinity. with a return of 12%. 6th Edition Solutions To Text Problems: Chapter 5 30 . Elton. one would hold the same portfolio one would hold without riskless lending and borrowing. Pair A (assets 1 and 2): Since the GMV portfolio of assets 1 and 2 has an expected return of 8% and a risk of 0%. zero net investment and positive return of 3%). the answer is the same as that above for Pair A. Gruber. passing through the portfolio where the line is tangent to the upper half of the original portfolio possibilities curve. With a riskless rate of 8%.C. The amount that is invested in the GMV portfolio and the amount that is borrowed or lent will depend on the investor’s degree of risk aversion. With a riskless rate of 5%. With an 8% riskless lending and borrowing rate. The amount that is invested in the tangent portfolio and the amount that is borrowed or lent will depend on the investor’s degree of risk aversion. the efficient frontier for this pair of assets was a single point representing the GMV portfolio.
The tangent (optimal) portfolio has an expected return of 12.94% and a standard deviation of 2. Gruber.27 V2C = 46. passing through the portfolio where the line is tangent to the upper half of the original portfolio possibilities curve.77 In this problem. the analytical solution to this problem is presented in the subsequent chapter (Chapter 6).Pair F (assets 3 and 4): We arrived at the following answer graphically.89 U BC = 0. With a riskless rate of 5%. and then out to infinity.95% R C = 7. With a riskless rate of 8%.92% V AB = 2.02 V C = 6. 6th Edition Solutions To Text Problems: Chapter 5 31 . The tangent (optimal) portfolio has an expected return of 12. the new efficient frontier will be a straight line extending from the vertical axis at the riskless rate.87% and a standard deviation of 2.24 U AC = 0. passing through the portfolio where the line is tangent to the upper half of the original portfolio possibilities curve.42 V B = 3.34 V A = 3.15 V2B = 14. we will examine 2asset portfolios consisting of the following pairs of securities: Pair 1 2 3 Securities A and B A and C B and C Elton.61%.22% R B = 2.64%.78% V BC = 19. The amount that is invested in the tangent portfolio and the amount that is borrowed or lent will depend on the investor’s degree of risk aversion. we know that: R A = 1. the new efficient frontier (efficient set) will be a straight line extending from the vertical axis at the riskless rate.17 U AB = 0.8% V AC = 7. Chapter 5: Problem 2 From Problem 2 of Chapter 4. and then out to infinity.92% V2A = 15. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
2 and A. Short Selling Not Allowed (Note that the answers to part A.95% 2.42 (2)(2.34 14.17 15.518 (or 51. the standard deviation and the expected return of the minimumrisk porfolio.) A.482 (or 48. We further know that the compostion of the GMV portfolio of any two assets i and j is: X iGMV V j2 V ij V i2 V j2 2V ij 1 X iGMV X GMV j Pair 1 (assets A and B): Applying the above GMV weight formula to Pair 1 yields the following weights: GMV XA 2 V B V AB V 2 A V 2 B 2V AB 14.518 u 2.8%) This in turn gives the following for the GMV portfolio of Pair 1: R GMV 2 V GMV 0.A.22% 0.482. A.1 We want to find the weights.1.2%) GMV XB GMV 1 X A 0. also known as the global minimum variance (GMV) portfolio.4 are integrated with the answers to parts A. of a pair of assets when short sales are not allowed.482 0.482 u 1.17) 1 0.12% 0.42 2.3 below.
34.2 15.
0.518.
2 14.42.
2.
0.482.
0.518.
2.17.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 5 32 . V GMV 2. Gruber.92% 8.52 Elton.
2 and A.342 2.38% 4.For the GMV portfolios of the remaining pairs above we have: Pair X iGMV X GMV R GMV V GMV j 2 (i = A. Elton.827 0.3 For each of the above pairs of securities. j = C) 0.65% 3.63% A. j = C) 3 (i = B. 6th Edition Solutions To Text Problems: Chapter 5 33 . starting at the GMV portfolio and ending at security B.173 0.73% 1. Gruber.658 0. the graph of all possible combinations (portfolios) of the securities (the portfolio possibilties curves) and the efficient set of those portfolios appear as follows when short sales are not allowed: Pair 1 The efficient set is the positively sloped part of the curve. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
6th Edition Solutions To Text Problems: Chapter 5 34 . starting at the GMV portfolio and ending at security C.Pair 2 The efficient set is the positively sloped part of the curve. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Pair 3 The efficient set is the positively sloped part of the curve. starting at the GMV portfolio and ending at security C. Elton. Gruber.
) B. Short Selling Not Allowed (Note that the answers to part B. the portfolio possibilities graphs are extended. 6th Edition Solutions To Text Problems: Chapter 5 35 . starting at the GMV portfolio and extending past security B toward infinity.4 are integrated with the answers to parts B.3 below. B.B.1 When short selling is allowed. all of the GMV portfolios shown in Part A.3 When short selling is allowed. Pair 1 The efficient set is the positively sloped part of the curve. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.1 above remain the same.2 and B. Gruber.1. Elton. B.2 and B.
Elton. Pair 3 The efficient set is the positively sloped part of the curve. Gruber. 6th Edition Solutions To Text Problems: Chapter 5 36 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.Pair 2 The efficient set is the positively sloped part of the curve. starting at the GMV portfolio and extending past security C toward infinity. starting at the GMV portfolio and extending past security C toward infinity.
in expected return standard deviation space. Chapter 5: Problem 3 The answers to this problem are given in the answers to part A. security C and security S) are described by the equations for two straight lines. In all cases where the riskless rate of either 5% or 8% is higher than the returns on both of the individual securities. for the first equation: V P = X C V C 1 X C . start with the expressions for a twoasset portfolio's standard deviation when the two assets' correlation is 1 (the equations in (5. one with a positive slope and one with a negative slope.1 of Problem 2. Chapter 5: Problem 4 The locations. since the original GMV portfolio’s return is lower than 5% in all cases. and solve for XC (the investment weight for security C).C. any rational investor would only invest in the riskless asset. E.. the point of tangency of a line connecting the riskless asset to the original portfolio possibilities curve occurs at infinity for all cases.g.8) in the text). Even if short selling is allowed. To derive those equations. if short sales are not allowed. of all portfolios composed entirely of two securities that are perfectly negatively correlated (say.
V S + XC V S V P + V S = X C (V C + V S ) V P +V S .V S V P = XC V C . XC = V C +V S Now plug the above expression for XC into the expression for a twoasset portfolio's expected return and simplify: RP = X C RC + 1 X C .
6th Edition Solutions To Text Problems: Chapter 5 37 . Gruber. Elton. V C + V S » «V C + V S » « ¼ ¼ ¬ ¬ The above equation is that of a straight line in expected return standard deviation space. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.RS § § + · + · = ¨ V P V S ¸RC + ¨1 V P V S ¸RS ¨ ¸ ¨ ¸ ©VC +V S ¹ © V C +V S ¹ + = RS + V P RC V S RC V P RS V S RS VC +V S º ª ª º = «RS + RC RS V S » « RC RS » V P . with an intercept equal to the first term in brackets and a slope equal to the second term in brackets.
8) gives: V P = X C V C + 1 X C .Solving for XC in the second equation in (5.
V S V P = XC V C + V S XC V S V P V S = X C V C + V S .
V S VP . XC = VC +V S Substitute the above expression for XC into the equation for expected return and simplify: RP = X C RC + 1 X C .
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. and since the investment weights must sum to 1. This requires X1 = 0 and X2 = 1. with an intercept equal to the first term in brackets and a slope equal to the second term in brackets. where the X's are the investment weights. X2 = 1 . P = 2 = 2. the two lines are coincident). and both lines meet at the same intercept. the other equation has a negative slope (when the expected returns of the two assets are equal. and P will equal 0. The standard deviation of this "combination" is equal to the standard deviation of security 2. So when one equation has a positive slope.RS § · § · = ¨ V S V P ¸RC + ¨1 V S V P ¸RS ¨ ¸ ¨ ¸ © V C +V S ¹ ©V C +V S ¹ + = RS + V S RC V P RC V S RS V P RS +V S VC º ª º ª = «RS + RC RS V S » « RS RC » V P .X1 = 1 . the least risky "combination" of securities 1 and 2 is security 2 held alone (assuming no short sales). Gruber.2/7 = 5/7. 6th Edition Solutions To Text Problems: Chapter 5 38 . When equals 1. So. Chapter 5: Problem 5 When equals 1. So a combination of 2/7 invested in security 1 and 5/7 invested in security 2 will completely eliminate risk when equals 1. we saw in Chapter 5 that we can always find a combination of the two securities that will completely eliminate risk. The intercept term for the above equation is identical to the intercept term for the first derived equation. The slope term is equal to 1 times the slope term of the first derived equation. and we saw that this combination can be found by solving X1 = 2/( 1 + 2). Elton. X1 = 2/(5 + 2) = 2/7. V C + V S » «V C + V S » « ¼ ¬ ¼ ¬ The above equation is also that of a straight line in expected return standard deviation space.
So. we saw in Chapter 5 that the minimumrisk combination of two assets can be found by solving X1 = 22/( 12 + 22).X1 = 1 . X1 = 4/(25 + 4) = 4/29.When equals 0.4/29 = 25/29. and X2 equals 0. When deviation of a twoasset portfolio is 2 2 2 V P = X1 V 1 1 X1. the expression for the standard = 1 .
Gruber. we have VP § 4 · § 25 · ¨ ¸ u 25 ¨ ¸ u 4 © 29 ¹ © 29 ¹ 400 2500 841 841 2900 841 1. 6th Edition Solutions To Text Problems: Chapter 5 39 . since it offers as much or higher expected return than either risky asset does. the optimal investment is the riskfree asset.86% 2 2 Chapter 5: Problem 6 If the riskless rate is 10%. for zero risk. then the riskfree asset dominates both risky assets in terms of risk and return. V 2 2 Substituting 4/29 for X1 in the above equation. Elton. Assuming the investor prefers more to less and is risk averse. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
6th Edition Solutions To Text Problems: Chapter 5 40 .Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.
084% The optimum portfolio has a mean return of 10.292831 Z2 = 0.106%. Gruber.Elton.02987 (2.929%) X2 = . 6th Edition Solutions To Text Problems: Chapter 6 41 .987%) X3 = .01084 (1.009118 Z3 = 0.003309 This results in the following set of weights for the optimum (tangent) portfolio: X1 = . Chapter 6: Problem 2 The simultaneous equations necessary to solve this problem are: 11 RF = 4Z1 + 10Z2 + 4Z3 14 RF = 10Z1 + 36Z2 + 30Z3 17 RF = 4Z1 + 30Z2 + 81Z3 Elton.146% and a standard deviation of 4. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.95929 (95. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions to Text Problems: Chapter 6 Chapter 6: Problem 1 The simultaneous equations necessary to solve this problem are: 5 = 16Z1 + 20Z2 + 40Z3 7 = 20Z1 + 100Z2 + 70Z3 13 = 40Z1 + 70Z2 + 196Z3 The solution to the above set of equations is: Z1 = 0. Gruber.
971% Chapter 6: Problem 3 Since short sales are not allowed.082790 RF = 10% 0.682350 0.080537 0. this problem must be solved as a quadratic programming problem.043624 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.419% 11.802% 2.510067 1.714100 0. 6th Edition Solutions To Text Problems: Chapter 6 42 .737% 0.105% 6.035290 0. Gruber.715950 0.The optimum portfolio solutions using Lintner short sales and the given values for RF are: RF = 6% 3.203100 0.194631 0.214765 0.711800 RF = 8% 1.010070 0.812% 0.348993 0.852348 0.526845 0.212870 0.282350 Z1 Z2 Z3 X1 X2 X3 Tangent (Optimum) Portfolio Mean Return Tangent (Optimum) Portfolio Standard Deviation 6. The formulation of the problem is: max T X RP RF VP subject to: ¦X i 1 N i 1 Xi t 0 i Elton.
” you then select “short sales allowed/riskless lending and borrowing” and then enter 4 for both the lending and borrowing rate and click “OK. but. To use the software. open up the Markowitz module. You may then hit the “Tab” key to jump to the tangent portfolio.676% 0. At that point. Gruber and Padberg “Simple Techniques” described in a later chapter.693% 59. since all pairs of assets are assumed to have the same correlation coefficient of 0. then click on “optimizer” and then “show portfolio” (or simply click on the “show portfolio” icon) to view and print the composition (investment weights).” A graph of the efficient frontier then appears.224% Elton.793% 3. the resulting investment weights for the optimum portfolio are as follows: Asset i 1 2 3 4 5 6 7 8 9 10 Xi 5. click on “optimizer” and then “run optimizer” (or simply click on the optimizer icon).” A table showing the investment weights of the tangent portfolio then appears.5.” If you select “full Markowitz. Regardless of the method used. Enter the input data into the appropriate cells by first double clicking on the cell to make it active.170% 14. the problem can also be solved manually using the constant correlation form of the Elton. you can either select “full Markowitz” or “simple method.478% 29. Once the input data have been entered. select “file” then “new” then “group constant correlation” to open up a constant correlation table.966% 21.442% 189.999% 17. mean return and standard deviation of the tangent (optimum) portfolio.585% 12. Gruber.” you then select “short sales allowed with riskless asset” and enter 4 for the riskless rate and click “OK. If instead you select “simple method. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 6 43 .Chapter 6: Problem 4 This problem is most easily solved using The Investment Portfolio software that comes with the text.
since the two portfolios are on the efficient frontier. A and B. are on the efficient frontier.83% Also. starting with the GMV portfolio and moving up along the efficient frontier (increasing the weight in portfolio A and decreasing the weight in portfolio B).907% and a standard deviation of 3.Given the above weights. the entire efficient frontier can then be traced by using various combinations of the two portfolios.297%.33% and V GMV 3. the GMV portfolio can be obtained by finding the minimumrisk combination of the two portfolios: GMV XA 2 V B V AB V 2 A V 2 B 2V AB 16 20 36 16 2 u 20 1 1 3 1 3 GMV XB GMV 1 X A This gives R GMV 7. Since XB = 1 XA the efficient frontier equations are: RP X A R A 1 X A . The efficient frontier is a positively sloped straight line starting at the riskless rate of 4% and extending through the tangent portfolio (T) and out to infinity: Chapter 6: Problem 5 Since the given portfolios. the optimum (tangent) portfolio has a mean return of 18.
R B 2 10 X A 8 u 1 X A .
VP 2 2 2 X AV A 1 X A .
V B 2 X A 1 X A .
V AB 2 36X A 161 X A
40 X A 1 X A
2
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions To Text Problems: Chapter 6
44
Since short sales are allowed. The efficient frontier appears as follows: Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. the efficient frontier will extend beyond portfolio A and out toward infinity. Gruber. 6th Edition Solutions To Text Problems: Chapter 6 45 .
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.Elton. 6th Edition Solutions To Text Problems: Chapter 6 46 .
118 20.876 9.005% Using data given in the problem and the above two sample mean monthly returns.886 0.946% The sample mean monthly return on the market portfolio (the answer to part 1.101 At .534 3.893 0.214 5.928 1.46 6.41 4.05 15.27 4.99 2.79 8.15 12 3.324 7.43 6.557 15. 6th Edition Solutions to Text Problems: Chapter 7 Chapter 7: Problem 1 We will illustrate the answers for stock A and the market portfolio (S&P 500). The sample mean monthly return on stock A is: RA ¦R t 1 12 At 12 12.E) is: Rm ¦R t 1 12 mt 12 12.57 3.066 1.804 4.75 7.16 2. Gruber.902 141.883 151.916 4. the answers for stocks B and C are found in an identical manner.41 4.00 R RA 82.47 1.519 96.881 49.77 2.48 0.94 12 2.16 2.046 32.736 11.Elton.48 4.991 17.126 1.11 3. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.376 0.28 5.18 1.07 12.97 1. we have the following: Month t 1 2 3 4 5 6 7 8 9 10 11 12 RAt RA 9.024 3.12 1.104 12.
286 17.455 3.264 .974 2.775 5.176 1.155 0.910 0.207 9.155 0.535 4.354 2.595 1.275 2.405 1.985 0.115 0.425 9.026 8.475 1.551 26.031 95.00 R mt Rm 86.954 0. 2 Rmt Rm 9.163 0.
1 0.17 116. 2 R At RA Rmt Rm 84.48 21.03 0.91 .15 296.93 2.2 2.85 30.79 4.3 8.43 16.44 36.
.
84 250. 6th Edition Solutions To Text Problems: Chapter 7 47 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.90 Elton. Sum 613.
The sample variance and standard deviation of the stock A’s monthly return are: 2 VA ¦ R 12 t 1 At RA .
F) and standard deviation of the market portfolio’s monthly return are: 2 Vm ¦ R 12 t 1 mt Rm .15 VA 51.15 7.84 12 51. 2 12 613.15% The sample variance (the answer to part 1.
91 Vm 20.57% The sample covariance of the returns on stock A and the market portfolio is: V Am ¦ >R 12 t 1 At RA Rmt Rm 12 .91 4.90 12 20. 2 12 250.
.
183 20.57 0.74 7.183 u 3.74 12 The sample correlation coefficient of the returns on stock A and the market portfolio (the answer to part 1.74 1. Gruber.946% 1.Pr edicted D A E ARmt 48 Elton. The regression’s predicted monthly return is: RA.A) is: DA RA E A Rm 2.609% Each month’s sample residual is security A’s actual return that month minus the return that month predicted by the regression.91 24.@ 296.t .91 The sample alpha of stock A (the answer to part 1. 6th Edition Solutions To Text Problems: Chapter 7 .B) is: EA V Am 2 Vm 24.D) is: U Am V Am V AV m 24. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.757 The sample beta of stock A (the answer to part 1.15 u 4.005% 0.
48 0.07 12.5 77.26 40.92 6.Pr edicted 13.84 26.93 2.C) are: V H2A ¦ H 12 At HA t 1 .00 2 H At 3.12 1.31 1.16 2.79 6.73 1.35 1.12 1.62 3.63 8.72 5.Pr edicted So we have the following: Month t 1 2 3 4 5 6 7 8 9 10 11 12 RAt 12.75 7.11 3.48 6.81 36.18 1.97 1.36 3.t.87 8.17 1.t .94 RA.05 15.68 2.41 6.07 5.57 3.79 8.27 4.97 Sum: H At 1.1 55.02 0.04 262.24 4.73 2.45 9.61 4. the sample mean of the sample residuals also equals 0 and the sample variance and standard deviation of the sample residuals (the answer to part 1.12 3.The sample residual for each month t is then: H At RAt RA.69 4.48 2.42 0.36 Since the sample residuals sum to 0 (because of the way the sample alpha and beta are calculated).45 7.06 0.
863 4. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.676% Elton.863 V HA 21. Gruber. 6th Edition Solutions To Text Problems: Chapter 7 49 . ¦H 12 At t 1 12 12 262.36 12 21.
91. simply multiply the N2 N 1 variance by either . A.609% Stock B 2.422% beta correlation with market standard deviation of sample residuals* with R m *Note 2 3.964% Stock C 3.322 0.1 The Sharpe singleindex model's formula for a security's mean return is Ri = D i + E i R m Using the alpha and beta for stock A along with the mean return on the market portfolio from Problem 1 we have: RA Similarly: RB 6.652 4. or N N Chapter 7: Problem 2 A.005% and V m 1.183 1.183 u 3.946% Elton. we have instead used N for the denominator in all the variance formulas. As is explained in the text. 6th Edition Solutions To Text Problems: Chapter 7 50 . 4.032% .Repeating the above analysis for all the stocks in the problem yields: Stock A alpha 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. RC 3.005 2.556% 0.983% 12.341% that most regression programs use N 2 for the denominator in the sample residual variance formula and use N 1 for the denominator in the other variance formulas (where N is the number of time series observations). To convert the variance from a regression program to our results.684 0. Gruber.609 1.021 2.757 0.676% 20.
The Sharpe singleindex model's formula for a security's variance of return is:
V i2
2 E i2 V m V H2i
Using the beta and residual standard deviation for stock A along with the variance of return on the market portfolio from Problem 1 we have:
2 VA
1.183 2 u 20.91 4.676 2
51.14
Similarly:
2 Vb 2 46.62 ; V c
265.0
A.2 From Problem 1 we have:
RA
2 VA
2.946% ; R B
2 51.15 ; V B
6.031% ; RC
2 46.61; V C
3.554%
265.0
B. B.1 According to the Sharpe singleindex model, the covariance between the returns on a pair of assets is:
SIMV ij
2 E i E jV m
Using the betas for stocks A and B along with the variance of the market portfolio from Problem 1 we have:
SIMV AB
1.183 u 1.021u 20.91 25.254
Similarly:
SIMV AC
57.433 ; SIMV BC
49.568
Elton, Gruber, Brown and Goetzmann Modern Portfolio Theory and Investment Analysis, 6th Edition Solutions To Text Problems: Chapter 7
51
B.2 The formula for sample covariance from the historical time series of 12 pairs of returns on security i and security j is:
V ij
¦ R
12 t 1
it
Ri Rjt Rj 12
the mean monthly return and standard deviation of an equally weighted portfolio of stocks A.618 . C.18% VP 2 2 2 2 2 § § 1 ·2 · § 1· § 1· § 1· ¨ ¨ ¸ u 25.348% C.25 § 1 · u 57.0 2 u ¨ ¨ ¸ u 18.031% u 3.43 § 1 · u 49.46 ¨ ¸ u 61.374% Elton. V AC 61.62 ¨ ¸ u 265. B and C gives: V AB 18. B and C are: RP 1 1 1 u 2. 6th Edition Solutions To Text Problems: Chapter 7 52 .0 2 u ¨© 3 ¹ ¸ ©3¹ ©3¹ ©3¹ ©3¹ ©3¹ © ¹ 8.1 Using the earlier results from the Sharpe singleindex model.032% u 3.2 Using the earlier results from the historical data.15 ¨ ¸ u 46.554% 3 3 3 4. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.946% u 6.62 ¨ ¸ u 265.462 .62 ¨ ¸ u 54.556% 3 3 3 4. the mean monthly return and standard deviation of an equally weighted portfolio of stocks A.57 ¸ ¨ ¸ ¨ ¸ ¨ ¸ u 51.15 ¨ ¸ u 46.085 C. Applying the above formula to the monthly data given in Problem 1 for securities A.08 ¸ ¨© 3 ¹ ¸ ©3¹ ©3¹ ©3¹ ©3¹ ©3¹ © ¹ 8.946% u 6. V BC 54.18% VP 2 2 2 2 2 § § 1 ·2 · § 1· § 1· § 1· § 1· § 1· ¨ ¸ u 51. B and C are: RP 1 1 1 u 2. Gruber.
V E 1 is the variance of all the sample securities’ betas in the 2 historical period and V Ei1 is the square of the standard error of the estimate of beta for security i in the historical period.1 and C. The slight differences between the answers to parts A. Chapter 7: Problem 3 Recall from the text that the Vasicek technique’s forecast of security i’s beta ( E i 2 ) is: E i2 2 V Ei1 2 2 V E 1 V Ei1 u E1 2 V E1 2 2 V E 1 V Ei1 u E i1 where E 1 is the average beta across all sample securities in the historical period (in this problem referred to as the “market beta”). we have: 2 V Ei1 a where a is a constant across all the sample securities. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. then.2 are simply due to rounding errors. Elton. The answers in parts C. B and C are identical because the Sharpe singleindex model formula for the mean return on an individual stock yields a result identical to that of the samplestatistics formula for the mean return on the stock. The answers in parts C.1 and A. The samplestatistics form of sample covariance of total returns incorporates the actual sample covariance of the sample residuals.1 and B.2 differ for sample covariance because the Sharpe singleindex model assumes the covariance between the residual returns of securities i and j is 0 (cov(Hi Hj ) = 0).1 and C. Gruber.D.2 for standard deviations of return on an equally weighted portfolio of stocks A. for each security i. and so the singleindex form of sample covariance of total returns is calculated by setting the sample covariance of the sample residuals equal to 0. E i1 is the beta of security i in the 2 historical period. The results for sample mean return and variance from either the Sharpe singleindex model formulas or the samplestatistics formulas are in fact identical. The answers to parts B. 6th Edition Solutions To Text Problems: Chapter 7 53 .2 for mean returns on an equally weighted portfolio of stocks A. If the standard errors of the estimates of all the betas of the sample securities in the historical period are the same. B and C are different because the Sharpe singleindex model formula for the sample covariance of returns on a pair of stocks yields a result different from that of the samplestatistics formula for the sample covariance of returns on a pair of stocks.
we have for any security i: E i2 a 2 V E1 a u E1 2 V E1 2 V E1 a u E i1 X E 1 1 X .Therefore.
120 E B2 1. for security A we have: R A = D A + E A Rm = 2 + 1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.60E i1 Using the earlier answer to Problem 1 for the estimate of beta from the historical period for stock A along with the above equation we obtain the stock’s forecasted beta: E A2 Similarly: 0.. 6th Edition Solutions To Text Problems: Chapter 7 54 . The singleindex model's formula for security i's mean return is Ri = D i + E i Rm Since Rm equals 8%.60E A1 0.41 0.803 Chapter 7: Problem 5 A.183 1. then the forecast period equals 2 and the Blume forecast equation is: Ei2 0.E i1 This shows that.g. e.60 u 1. the forecasted beta for any security using the Vasicek technique is a simple weighted average (proportional weighting) of E 1 (the “market beta”) and E i1 (the security’s historical beta).023 . Chapter 7: Problem 4 Letting the historical period of the year of monthly returns given in Problem 1 equal 1 (t = 1). under the assumption that the standard errors of all historical betas are the same.41 0. Gruber. E C2 1. where the weights are the same for each security.41 0. then.5 x 8 = 2 + 12 = 14% Elton.
4% .5. RD 11. Since m = 5.2% B.4% . The singleindex model's formula for security i's own variance is: 2 2 2 2 V i = E i V m + V ei . then.g. RC 7.. e.Similarly: RB 13. for security A we have: V A = E A V m + V eA 2 2 2 2 = 1.
u 5.
3 .
5 u 1.25 Similarly: 2B = 43.25 C. CD = 18 Chapter 7: Problem 6 A. 6th Edition Solutions To Text Problems: Chapter 7 55 . 2 2 2 = 65. e. BC = 26.3 u 25 = 48. where N is the number of assets in the portfolio. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.25. then. 2D = 36. AD = 33. BD = 29. Elton..75 Similarly: AC = 30. Recall that the formula for a portfolio's beta is: E P = ¦ Xi E i i =1 N The weight for each asset (Xi) in an equally weighted portfolio is simply 1/N. for securities A and B we have: V AB = E A E B V m 2 = 1. The singleindex model's formula for the covariance of security i with security j is V ij = V ji = E i E j V m 2 Since 2m = 25.g.75. 2C = 20.25.
Since there are four assets in Problem 5.3 0. So: EP = 1 1 1 1 EA EB EC ED 4 4 4 4 1 = 1.9. N = 4 and Xi equals 1/4 for each asset in an equally weighted portfolio of those assets.8 0.5 1.
Recall that the definition of a portfolio's alpha is: D P = ¦ Xi D i i =1 N Using 1/4 as the weight for each asset. 4 1 = u 4.5 4 = 1.125 B. we have: DP = 1 1 1 1 DA DB DC DD 4 4 4 4 1 = 2 3 1 4 .
we have: V 2 P 1.25. Recall that a formula for a portfolio’s variance using the singleindex model is: 2 VP 2 2 2 E P V m ¦ Xi2V ei i 1 N Using 1/4 as the weight for each asset.5 C. 4 1 = u 10 4 = 2.
5.
§ 1 · 3.
2 § 1 · 1.
2 § 1 · 2.
2 § 1 · 4.
25.2 ¨ ¸ ¨ ¸ ¨ ¸ ¨ ¸ ©4¹ ©4¹ ©4¹ ©4¹ 1.
2 u 25 1 9 1 4 16.
16 33. 6th Edition Solutions To Text Problems: Chapter 7 56 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.52 2 2 2 2 2 2 Elton.
D. Using the singleindex model’s formula for a portfolio’s mean return we have:
RP
D P E P Rm
2.5 1.125 u 8 11.5%
Chapter 7: Problem 7 Using E i 2 0.343 0.677E i1 and the historical betas given in Problem 5 we can forecast, e.g., the beta for security A:
E A2
0.343 0.677E A1 0.343 0.677 u 1.5 0.343 1.0155 1.3585
Similarly:
E B2
1.2231; E C2
0.8846 ; E D2
0.9523
Chapter 7: Problem 8 Using the historical betas given in Problem 5 and Vasicek’s formula, we can forecast, e.g., the beta of security A:
E A2
2 2 V E1 V EA1 u E1 2 u E A1 2 2 2 V E 1 V EA1 V E 1 V EA1
0.21
2 0.25
2 u 1 u 1.5 0.25
21.2 0.
2 0.25.
2 0.21.
5 0.0441 0.2932 Similarly: E B 2 1.0625 0. 6th Edition Solutions To Text Problems: Chapter 7 57 .2 0.0441 0.5 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.4137 u 1 0.5863 u 1.0625 u 1 u 1.8683 .9390 Elton.1137 . Gruber.0625 0.4137 0. E D2 0.0441 0.8795 1. E C2 0.
where the proportion is a constant across all securities equal to U* . including i and j. 6th Edition Solutions to Text Problems: Chapter 8 Chapter 8: Problem 1 Given the correlation coefficient of the returns on a pair of securities i and j. the singleindex model’s expression for the covariance between the returns on a pair of securites is: 2 SIMV ij E i E jV m V im V jm 2 u 2 u Vm 2 Vm Vm U imV iV m U jmV jV m 2 u u Vm 2 2 Vm Vm U imU jmV iV j If the assumptions of both the constant correlation and singleindex model hold. 6th Edition Solutions To Text Problems: Chapter 8 . for any security i we have: U jm U km U imV i Vm U* U* uV i Vm Ei V im 2 Vm U imV i V m 2 Vm In other words. U * . Gruber. Vm 59 Elton. each security’s beta is proportional to its standard deviation. So we have: U* U im U jm U * U imU km U jmU km U* The only solution to the above set of equations is: U im Therefore. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. then the constantcorrelation expression for covariance is: CCV ij U *V iV j Given the assumptions of the Sharpe singleindex model. i and k and j and k. the securities’ covariance can be expressed as the securities’ correlation coefficient times the product of their standard deviations: V ij U ijV iV j But if we assume that all pairs of securities have the same constant correlation. Gruber. then we have CCV ij SIMV ij : U *V iV j U imU jmV iV j or U * U im U jm This must hold for all pairs of securities. given that all pairs of securities have the same correlation coefficient and that the Sharpe singleindex model holds.Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
Chapter 8: Problem 2 Start with a general 3index model of the form: Ri * Set I1 * * * ai* bi*1 u I1 bi*2 u I2 bi*3 u I3 ci (1) I1 and define an index I2 which is orthogonal to I1 as follows: * I2 J 0 J 1 u I1 d t or I2 dt * I2 J 0 J 1 u I1.
which gives: * I2 J 0 J 1 u I1 I2 Substituting the above expression into equation (1) and rearranging we get: Ri a * i * bi*2 u J 0 bi*1 bi*2 u J 1 u I1 bi*2 u I2 bi*3 u I3 ci .
.
c The first term in the above equation is a constant. which we can define as a1 . The coefficient in the second term of the above equation is also a constant. which we c can define as bi1 . We can then rewrite the above equation as: Ri c c * ai bi1 u I1 bi*2 u I2 bi*3 u I3 ci (2) Now define an index I3 which is orthogonal to I1 and I2 as follows: * I3 T0 T1 u I1 T 2 u I2 et or I 3 et * I 3 T 0 T 1 u I1 T 2 u I 2 .
which gives: * I3 T 0 T 1 u I1 T 2 u I 2 I 3 Substituting the above expression into equation (2) and rearranging we get: Ri § a c b u T · § b c b u T · u I b* b* u T u I b* u I c ¨ ¨ i i3 0¸ i3 1¸ i2 i3 2 2 i3 3 i ¹ 1 © ¹ © i1 .
the first term and all the coefficients of the new orthogonal indices are constants. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 8 60 . Gruber. In the above equation. so we can rewrite the equation as: Ri ai bi1 u I1 bi 2 u I2 bi 3 u I3 ci Elton.
Chapter 8: Problem 3 Recall from the earlier chapter on the singleindex model that an expression for the covariance of returns on two securities i and j is: V ij 2 E i E j Eª Rm Rm º E j E ei Rm Rm E i E ej Rm Rm E>ei ej @ » « ¬ .
¼ > .
@ > .
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 8 61 . Gruber.@ The first term contains the variance of the market portfolio. Given that one of the model’s assumptions is that the covariance of the market portfolio with the residuals is zero and that. the second two terms contain the covariance of the market portfolio with the residuals and the last term is the covariance of the residuals. the covariance of the residuals equals a constant K. the derived covariance between the two securities is: V ij 2 E i E jV m K One expression for the variance of a portfolio is: 2 VP ¦ i 1 N Xi2V i2 ¦¦X X V j k j 1 k 1 kz j N N jk Recalling that the singleindex model’s expression for the variance of a security is 2 2 V i2 E i2V m V ei and substituting that expression and the derived expression for covariance into the above equation and rearranging gives: 2 VP ¦ i 1 N N 2 Xi2 E i2V m ¦ i 1 j N 2 Xi2V ei ¦¦ j 1 k 1 kz j 2 ei 2 i N N 2 X j Xk E j E kV m ¦¦X X K j k j 1 k 1 kz j N N ¦¦X X E EV i j i i 1 j 1 N 2 m ¦X V i 1 N i 1 N ¦¦X X K j k j 1 k 1 kz j N N § ¨ ¨ © ¦ i 1 2 P N ·§ Xi E i ¸¨ ¸¨ ¹© N 2 m ¦ i N · 2 Xi E i ¸V m ¸ 1 ¹ ¦ N 2 Xi2V ei ¦¦X X K j k j 1 k 1 kz j N N E V ¦ i 1 Xi2 V 2 ei § ¨ K¨ ¨ © ¦¦ j 1 N · ¸ X j Xk ¸ ¸ k 1 kz j ¹ Elton. from the problem.
Chapter 8: Problem 4 Using the result from Problem 2. we have the following expression for expected return: Ri a i b i1 u I1 b i 2 u I 2 b i 3 u I 3 The variance formula is: V i2 E ªb I I . we have: Ri ai bi1 u I1 bi 2 u I2 bi 3 u I3 ci Since the residual ci always has a mean of zero (by construction if necessary).
b I « ¬ i1 1 1 E ª ai bi1 u I1 bi 2 u I2 bi 3 u I3 ci ai bi1 u I1 bi 2 u I2 bi 3 u I3 « ¬ i2 2 2 I2 bi 3 I3 I3 ci º » ¼ .
.
.
.
.
noting that the indices are all orthogonal with each other and making the usual assumption that the residual is uncorrelated with any index gives us: 2 V i2 bi2V I2 bi22V I2 bi23V I2 V ci 1 1 2 3 The covariance formula is: V i2 ª ai bi1 u I1 bi 2 u I2 bi 3 u I3 ci ai bi1 u I1 bi 2 u I2 bi 3 u I3 E« «u a j b j1 u I1 b j 2 u I2 b j 3 u I3 c j a j b j1 u I1 b j 2 u I2 b j 3 u I3 ¬ E bi1 I1 I1 bi 2 I2 I2 bi 3 I3 I3 ci u b j1 I1 I1 b j 2 I2 I2 b j 3 I3 I3 c j > . º » ¼ 2 Carrying out the squaring.
.
.
.
.
.
.
.
.
.
º » » ¼ .
.
6th Edition Solutions To Text Problems: Chapter 8 62 .@ Carrying out the multiplication. making the usual assumption that the residuals are uncorrelated with any index and assuming that the residuals are uncorrelated with each other gives us: V ij bi1b j1V I2 bi 2 b j 2V I2 bi 3 b j 3V I2 1 2 3 Elton. noting that the indices are all orthogonal with each other. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
g.Chapter 8: Problem 5 The formula for a security's expected return using a general twoindex model is: Ri ai bi1 u I1 bi 2 u I 2 Using the above formula and data given in the problem. the expected return for.6% The twoindex model’s formula for a security’s own variance is: V i2 2 bi2V I2 bi2 V I2 V ci 1 1 2 2 Using the above formula.g.9 u 4 12% Similarly: RB 17% .8 u 8 0.8. e. RC 12. e... security A is: RA a A b A1 u I1 b A2 u I 2 2 0. security A is: 2 VA 2 2 2 b A1V I2 b A2V I2 V cA 1 2 0. the variance for.
2 2.
2 0.9.
2 2.5.
2 2.
2B 11.0625 4 Similarly. security A with security B is: V AB b A1bB1V I2 b A2 bB2V I2 1 2 0..0525.8. The twoindex model's formula for the covariance of security i with security j is: V ijj bi1b j1V I2 bi 2 b j 2V I2 1 2 Using the above formula. the covariance of. C.4025.6225 = 16. and 2C = 13. e.g.2 2.56 5.
1.1.
2.
9.2 0.
3.1.
5.2.
8325 Similarly. 63 Elton. 6th Edition Solutions To Text Problems: Chapter 8 . Gruber.8975.52 7. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. AC = 9. and BC = 12.3125 10.2 3.0675.
then: V AB 2 b Am bBmV m b A2 bB 2V I2 2 0. the covariance between their securities' returns is given by: V ik 2 2 bim bkmV m bij bkj V Ij Otherwise. if the firms are in different industries. the covariance of their securities' returns is given by: V ik 2 bim bkmV m If only firms A and B are in the same industry. the text gives two formulas for the covariance between securities i and k.Chapter 8: Problem 6 For an industryindex model.8. If firms i and k are both in industry j.
1.1.
2.
9.2 0.
3.1.
2.5.
8 .52 7.3125 10.8325 The second formula should be used for the other pairs of firms: V AC 2 b Am bCmV m 0.2 3.
0.9.
2 .
1.88 1.2 V BC 2 bBm bCmV m 2.
9.0.
2.
2 Chapter 8: Problem 7 3.1. So for firms B and C. except that now only firms B and C are in the same industry. the covariance between their securities' returns is: V BC 2 bBm bCmV m bB2 bC2V I2 2 1.96 The answers for this problem are found in the same way as the answers for problem 6.
0.9.
2.
3.2 1.
1.1.
2.5.
6th Edition Solutions To Text Problems: Chapter 8 64 .9375 12.96 8. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.8975 Elton.2 3.
The other formula should be used for the other pairs of firms: V AB 2 b Am bBmV m 0.8.
1.1.
2.
2 V AC 2 b Am bCmV m 3.8.52 0.
9.0.
2.
2 I*2 + ci = 2 + 1. I1 is defined as being equal to I*1 .2 Chapter 8: Problem 8 2. then I*2 is regressed on I1 to obtain the given regression equation. So. dt is an orthogonal index to I1.2 + 2.2 + 1.66 I1 + 1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.3 I1.2 I2 + ci The twoindex model has now been transformed into one with orthogonal indices I1 and I2. Elton. and I2 = dt = I*2 . Since dt is uncorrelated with I1 by the techniques of regression analysis. where I1 = I*1. Gruber. use the procedure described in Appendix A of the text.1.88 To answer this problem.2 (1 + 1.1 I*1 + 1. 6th Edition Solutions To Text Problems: Chapter 8 65 .1 I1 + 1. Then express the given regression equation as: I*2 = 1 + 1. Now.56 I1 + 1.3 I1 + I2) + ci = 2 + 1.1 I1 + 1. First.1 .2 I2 + ci = 3. substitute the above equation for I*2 into the given multiindex model and simplify: Ri = 2 + 1. define I2 = dt.3 I1 + I2.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.Elton. 6th Edition Solutions To Text Problems: Chapter 8 66 .
the securities are ranked in descending order by their excess return over beta. Gruber.6667 4. Security Rank i 1 6 2 5 4 3 1 2 3 4 5 6 Ri RF 10 9 7 4 3 6 Ri RF Ei 10.Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0000 R R .7500 3.0000 4.0000 3. 6th Edition Solutions to Text Problems: Chapter 9 Chapter 9: Problem 1 In the table below. given that the riskless rate equals 5%.0000 6.
5250 0.6833 2.0640 0.3000 § R j RF E j ¨ 2 ¨ V ej 1© 0.4083 2.2083 2.1125 0.E i F i 2 V ei E i2 2 V ei 0.6483 2.2250 0.2400 0.3500 0.3333 1.1000 ¦ j i 0.2000 0.3333 1.0333 0.9483 .0500 0.
6242 4.5000 4.0333 0. if the Sharpe singleindex model holds: 2 V m¨¦¨ Ci § R j RF E j · · ¸¸ 2 ¨ ¨ ¸¸ V ej ¹¹ © j 1© 2 · § i § Ej · 2 1 V m ¨ ¨ 2 ¸ ¸ ¨ j 1 ¨ V ¸¸ © © ej ¹ ¹ i § .3708 0.4848 0.6980 4.5286 4.3053 The numbers in the column above labeled Ci were obtained by recalling from the text that.4208 0.6910 4.5848 i Ci 2. · ¸ ¸ ¹ ¦ § E j2 · ¸ ¨ 2 ¨ V ej ¸ j 1© ¹ 0.2583 0.
given that V m = 10: C1 10 u 0. but we did not so that we R RF could demonstrate that i C i for all of the remaining lower ranked securities Ei as well.500 C2 4.833 3. We could have stopped our R RF calculations after the first time we found a ranked security for which i Ci . 6th Edition Solutions To Text Problems: Chapter 9 67 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. security 2).583 2.6833 1 10 u 0. only securities 1 and 6 (the highest and second highest ranked securities in the above table) are in the optimal (tangent) portfolio. Ei (in this case the third highest ranked security. With no short sales.333 1. we only include those securities for which Ri RF Ei ! C i . ¦ 2 Thus.2583 3. Elton. Gruber. Thus.698 etc.3333 1 10 u 0.0333 10 u 1.333 16.
where i = 2) is the last ranked R RF security in descending order for which i ! C i .698 and Ei solve for the optimum portfolio’s weights using the following formulas: § Ei ¨ ¨V 2 © ei · ·§ Ri RF ¸¨ C* ¸ ¸¨ E ¸ i ¹© ¹ Zi Xi Zi ¦Z i 1 2 i This gives us: Z1 § 1 · ¨ ¸10 4.Since security 6 (the second highest ranked security.698. we set C* = C2 = 4.
5 · ¨ ¸6 4. © 30 ¹ § 1.698.
6th Edition Solutions To Text Problems: Chapter 9 68 . Elton.5% invested in security 1 and 52. © 10 ¹ 0. Therefore.525 Since i = 1 for security 1 and i = 2 for security 6.3053. the optimum (tangent) portfolio when short sales are not allowed consists of 47.1953 Z1 Z 2 0.1767 Z2 0. Gruber.3720 0. all securities are included and C* is equal to the value of Ci for the lowest ranked security. Chapter 9: Problem 2 This problem uses the same input data as Problem 1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.1767 0.475 0. we see that the lowest ranked security is security 3. Referring back to the table given in the answer to Problem 1.1953 0. where i = 6.5% invested in security 6.3720 0. we have C* = C6 = 4.1953 X1 0.3720 X2 0.1767 0. When short sales are allowed.
3053. we use the following formulas: Zi § Ei ¨ ¨V 2 © ei · ·§ Ri RF ¸¨ C* ¸ ¸¨ E ¸ i ¹© ¹ and Xi Zi ¦Z i 1 6 (for the standard definition of short sales) i or Xi Zi ¦Z i 1 6 (for the Lintner definition of short sales) i So we have: Z1 § 1 · ¨ ¸10 4.To solve for the optimum portfolio’s weights.
5 · ¨ ¸6 4.3053. © 30 ¹ § 1.
1898 Z2 0.667 4.5 · ¨ ¸4. © 10 ¹ 0.2542 Z3 § 1.3053.
3053. © 20 ¹ § 1 · ¨ ¸4 4.
8 · ¨ ¸3.75 4. © 20 ¹ 0.0271 Z4 0.0153 Z5 § 0.3053.
3053. © 10 ¹ § 2.0 · ¨ ¸3 4.
0153 0. © 40 ¹ 0.1898 0.5961 Elton.1898 0.0653 0.0653 0. 6th Edition Solutions To Text Problems: Chapter 9 69 .2542 0. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0153 0.2542 0.0444 0.0444 0.0271 0.0271 0.0653 ¦Z i 1 6 i 0.0444 Z6 0.3461 ¦Z i 1 6 i 0.
5484 Lintner Definition X1 0. By simply solving Problem 2 using a different value for RF .5961 0. 6th Edition Solutions To Text Problems: Chapter 9 70 . As is described in the text.3461 0.0444 0.1095 Chapter 9: Problem 3 With short sales allowed but no riskless lending or borrowing.5961 0.0783 0.7345 X2 0.3461 0.3461 0. which is the efficient frontier when riskless lending and borrowing do not exist.5961 0.5961 0. the optimum portfolio depends on the investor’s utility function and will be found at a point along the upper half of the minimumvariance frontier of risky assets. another portfolio on the efficient frontier can be found and then the entire efficient frontier can be traced using combinations of those two efficient portfolios.5961 0.4264 Security 2 (i = 3) X3 0.This gives us the following weights (by rank order) for the optimum portfolios under either the standard definition of short sales or the Lintner definition of short sales: Standard Definition Security 1 (i = 1) X1 0. Elton. Gruber.0442 X3 0.3184 Security 6 (i = 2) X2 0.2542 0.0153 0.1887 X6 0. the entire efficient frontier of risky assets can be delineated with various combinations of any two efficient portfolios on the frontier.1898 0.0444 0.0455 0.2542 0.0271 0.1898 0.0745 Security 3 (i = 6) X6 0.1283 X5 0.0653 0.0257 Security 5 (i = 4) X4 X4 Security 4 (i = 5) X5 0.0153 0.0271 0.3461 0.0653 0.3461 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. One such efficient portfolio was found in Problem 2.5961 0.3461 0.
90 0.00 0.00 2.00 1.25 5.70 0.00 3.55 ¦ j i 1 2 5 6 4 3 7 1 2 3 4 5 6 7 10 15 5 9 7 13 11 § R j RF ¨ ¨ Vj 1© 1. given that the riskless rate equals 5%. Ri R F Ri RF Security Rank i Vi 1.60 5.00 3.80 .90 4. the securities are ranked in descending order by their excess return over standard deviation.Chapter 9: Problem 4 In the table below.00 1.65 0.
5000 0.2000 0.7502 0.3333 0.7668 0.· ¸ ¸ ¹ U 1 U iU 0.1250 Ci 0. if the constantcorrelation model holds: · § § U ¨ ¨ ¸ ¨ 1 U iU ¸ u ¨ ¹ © © Ci ¦¨ ¨ j i § R j RF · · ¸¸ V j ¸¸ 1© ¹¹ .5000 0.7250 The numbers in the column above labeled Ci were obtained by recalling from the text that.7500 0.1667 0.6667 0.2500 0.7800 0.1429 0.
0.0 0.0 0. Elton.5 for all pairs of securities: C1 0. we only include those securities for which Ri RF Vi ! C i . We could have stopped our calculations R RF C i . Thus.3333 u 2. Thus. 6th Edition Solutions To Text Problems: Chapter 9 71 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. given that U = 0. only securities 1.5 u 1. 5 and 6 (the four highest ranked securities in the above table) are in the optimal (tangent) portfolio.5000 C2 etc. Gruber. (in this case after the first time we found a ranked security for which i Vi the fifth highest ranked security.6667 With no short sales. but we did not so that we could R RF C i for all of the remaining lower ranked securities as demonstrate that i Vi well. security 4). 2.
we set C* = C4 = 0.Since security 6 (the fourth highest ranked security.78 and solve Vi for the optimum portfolio’s weights using the following formulas: § 1 ¨ ¨ 1 U . where i = 4) is the last ranked R RF security in descending order for which i ! C i .
5.V i © · ·§ Ri RF ¸¨ C* ¸ ¸¨ V ¸ i ¹© ¹ Zi Xi Zi ¦Z i 1 4 i This gives us: Z1 · § 1 ¨ ¨ 0.
10 .
78 . ¸1 0.
¸ © ¹ · § 1 ¨ ¸ ¨ 0.5.
15.
¸1 0.78.
© ¹ § 1 · ¨ ¨ 0.5.
5.
¸1 0.78.
0440 Z2 0.5.0293 Z3 0.0880 Z4 § · 1 ¨ ¨ 0. ¸ © ¹ 0.
10 .
¸0.78 .9 0.
6th Edition Solutions To Text Problems: Chapter 9 72 .0880 0.1581 X3 0.0293 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.1853 0.0240 0. 15. Gruber.0240 0.4749 X4 0.0880 0.0293 0. i = 3 for security 5 and i = 4 for security 6. the optimum (tangent) portfolio when short sales are not allowed consists of 23.75% invested in security 1. ¸ © ¹ 0.1853 0.0240 Z1 Z 2 Z 3 Z 4 X1 0. i = 2 for security 2.0440 0.1295 Since i = 1 for security 1. 47.95% invested in security 6.1853 0.0440 0.1853 0. Elton.1853 0.81% % invested in security 2.49% % invested in security 5 and 12.2375 X2 0.
we see that the lowest ranked security is security 7.725. Referring back to the table given in the answer to Problem 4. we have C* = C7 = 0. we use the following formulas: § 1 ¨ ¨ 1 U . To solve for the optimum portfolio’s weights. When short sales are allowed.Chapter 9: Problem 5 This problem uses the same input data as Problem 4. all securities are included and C* is equal to the value of Ci for the lowest ranked security. Therefore. where i = 7.
5.V i © · ·§ Ri RF ¸¨ C* ¸ ¸¨ V ¸ i ¹© ¹ Zi and Xi Zi ¦Z i 1 7 (for the standard definition of short sales) i or Xi Zi ¦Z i 1 7 (for the Lintner definition of short sales) i So we have: Z1 Z2 Z3 Z4 Z5 Z6 Z7 § · 1 ¨ ¨ 0.
10 .
725. ¸1 0.
5. 0.0550 ¸ © ¹ § · 1 ¨ ¨ 0.
15.
725. ¸1 0.
0.0367 ¸ © ¹ § 1 · ¨ ¨ 0.5.
5.
¸1 0.725.
5.1100 ¸ © ¹ § · 1 ¨ ¨ 0. 0.
10 .
9 0.725. ¸0.
5. 0.0350 ¸ © ¹ § · 1 ¨ ¨ 0.
10 .
7 0.725. ¸0.
0050 ¸ © ¹ § · 1 ¨ ¨ 0.5. 0.
20.
¸0.65 0.725.
5.0075 ¸ © ¹ § · 1 ¨ ¨ 0. 0.
20 .
¸0.55 0.725.
0075 0.0075 0. 6th Edition Solutions To Text Problems: Chapter 9 .0367 0.2067 ¦Z i 1 7 i 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0050 0.0350 0.0050 0.0175 ¦Z i 1 7 i 0.0175 0.0367 0.1100 0.0550 0. ¸ © ¹ 0.0175 0. Gruber.1100 0.0350 0.0550 0.2667 73 Elton.
2667 0. the optimum portfolio depends on the investor’s utility function and will be found at a point along the upper half of the minimumvariance frontier of risky assets. Gruber.1100 0.2661 Lintner Definition X1 0.2067 0.4124 Security 6 (i = 4) X4 0.0350 0. By simply solving Problem 5 using a different value for RF .This gives us the following weights (by rank order) for the optimum portfolios under either the standard definition of short sales or the Lintner definition of short sales: Standard Definition Security 1 (i = 1) X1 0.0175 0.0050 0.2667 0.1776 X2 0.2067 0.1376 Security 5 (i = 3) X3 0. the entire efficient frontier of risky assets can be delineated with various combinations of any two efficient portfolios on the frontier. 6th Edition Solutions To Text Problems: Chapter 9 74 .2067 0.2667 0. One such efficient portfolio was found in Problem 5.0075 0.0847 X7 0.0367 0.0175 0.0367 0.2067 0.0281 Security 7 (i = 7) X7 0.0550 0.2067 0.0350 0.5322 X3 0.2667 0.2667 0.0363 X6 0.2067 0.1100 0.0187 Security 3 (i = 6) X6 0. As is described in the text. Elton.0050 0. another portfolio on the efficient frontier can be found and then the entire efficient frontier can be traced using combinations of those two efficient portfolios.0656 Chapter 9: Problem 6 With short sales allowed but no riskless lending or borrowing.2667 0. which is the efficient frontier when riskless lending and borrowing do not exist.2667 0.1703 X4 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0242 X5 0.0075 0.0550 0.1312 Security 4 (i = 5) X5 0.2062 Security 2 (i = 2) X2 0.2067 0.
Since the last outcome in investment B has a probability of 1/4.45 + 1/3 u 0.5 + 1/5 u 144.38 + 1/4 u 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.Elton.75 Expected utility of investment C = 1/5 u 0. So we need to solve for the probabilities of those two outcomes that make investment B’s expected utility level equal to that of A’s.39 Expected utility of investment C = 1/5 u 1 + 3/5 u 0. Therefore we have: X u 9 + (3/4 X) u 18.5 = 17.16 = 16.33 + 1/5 u 0.50 + 1/2 u 0.5 + 1/4 u 40. the expected utility of investment B must be set equal to that of investment A.32 = 0. Gruber.5 + 3/5 u 31. Referring back to Problem 3.5 + 1/3 u 12. Gruber.8 Investment A is preferred because it has the highest level of expected utility. 6th Edition Solutions to Text Problems: Chapter 10 Chapter 10: Problem 1 Expected utility of investment A = 1/3 u 7.08 Expected utility of investment B = 1/2 u 9 + 1/4 u 18. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Chapter 10: Problem 3 Expected utility of investment A = 2/5 u 12.0 + 1/2 u 17.45 Investment B is preferred because it has the highest level of expected utility.24 = 0.08 Elton.0 Expected utility of investment B = 1/4 u 4. the first two probabilities must sum to 3/4.24 + 1/4 u 24 = 15. Chapter 10: Problem 4 For an investor to be indifferent.24 + 1/4 u 24 = 16.0 = 19.0 = 47. we see that the given probabilities are for the first two of the three outcomes in investment B.41 + 1/3 u 0.04 + 1/5 u 16 + 2/5 u 20.40 Expected utility of investment B = 1/4 u 0. Chapter 10: Problem 2 Expected utility of investment A = 1/3 u 0.5 + 1/3 u 31. 6th Edition Solutions To Text Problems: Chapter 10 75 .33 = 0.06 Investment A is preferred because it has the highest level of expected utility.
11 to 0.39 Therefore.11 to 0.39. Chapter 10: Problem 5: Given UW .36.Solving for X: X = 0.5 would have to be reduced by 0.25 would have to be increased by 0. and the second outcome’s probability of 0. the first outcome’s probability of 0.
W 1/ 2 . then UcW .
1 W 3 / 2 and UccW .
2 3 5 / 2 W . Therefore: 4 AW .
3 5 / 2 W 4 1 W 3 / 2 2 3 W 2 0 2 3 3 / 2 W 4 1 W 3 / 2 2 3 1 W 2 AcW .
RW .
3 2 RcW .
0 Therefore the utility function exhibits decreasing absolute risk aversion and constant relative risk aversion. Chapter 10: Problem 6 Given UW .
ae bW . then UcW .
abe bW and UccW .
ab 2 e bW . If the investor prefers more to less. then UcW .
! 0 . if the investor is also risk averse. then UccW .
for UcW . 0 . Since e bW ! 0 .
! 0 and UccW .
this means that a must be negative (a < 0). Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 0 we need ab ! 0 and ab 2 0 . Gruber. Since b 2 ! 0 . which in turn means that b must be positive (b > 0). 6th Edition Solutions To Text Problems: Chapter 10 76 . Elton.
Chapter 10: Problem 7 Given UW .
a be cW . then UcW .
bce cW and UccW .
then UcW . bc 2 e cW . If the investor prefers more to less.
! 0 . if the investor is also risk averse. then UccW .
for UcW . 0 . Since e cW ! 0 .
! 0 and UccW .
0 we need bc ! 0 and bc 2 0 . for UW . Furthermore. Since must also be negative (c < 0).
we have: AW . we need a t be cW . this means that b must be negative (b < 0). which in turn means that c be cW 0 when b < 0. Regarding the utility function’s properties of absolute and relative risk aversion. t 0 . since c 2 ! 0 .
AcW .
RW .
bc 2 e cW bce cW 0 c bc 2 WecW bce cW cW RcW .
c ! 0 Therefore the utility function exhibits constant absolute risk aversion and increasing relative risk aversion (since c < 0). Chapter 10: Problem 8 Given UW .
W 1/ 2 and W > 0. then: UcW .
UccW .
1 3 / 2 W ! 0 (individual prefers more wealth to less) 2 3 W 5 / 2 0 (individual is risk averse) 4 3 5 / 2 W 4 1 3 / 2 W 2 AW .
3 1 W 2 AcW .
3 W 2 0 (decreasing absolute risk aversion) 2 Elton. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 10 77 .
RW .
3 3 / 2 W 4 1 3 / 2 W 2 3 2 RcW .
0 (constant relative risk aversion) Chapter 10: Problem 9 Given UW .
e W and W > 0. then: UcW .
UccW .
AW .
AcW .
RW .
e W ! 0 (individual prefers more wealth to less) e W 0 (individual is risk averse) e W e W 1 0 (constant absolute risk aversion) We W e W W RcW .
Recall that the formula for expected utility of wealth (E[U(W)]) is: E>UW . 1! 0 (increasing relative risk aversion) Chapter 10: Problem 10 The investor will prefer the investment that maximizes expected utility of terminal wealth.
@ ¦ UW .
u PW .
W where each P(W) is the probability associated with each particular outcome of wealth (W). Since UW .
05W 2 . we have: Investment A: E>UW . W 0.
2 4.75 u 0.3 4.5 5 u 0.55 u 0.525 5 0.05 u 5 .@ 3.
05 u 7 .u 0.2 7 0.
05 u 10 .5 10 0.u 0.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. 6th Edition Solutions To Text Problems: Chapter 10 78 .u 0.3 2 2 2 Elton.
Investment B: E>UW .
8 9 0.05 u 6 2 u 0.635 .05 u 8 2 u 0.6 4.3 4.05 u 9 2 u 0.3 8 0.1 4.@ 6 0.1 4.2 u 0.95 u 0.8 u 0.
.
.
set the expected utility of investment A in Problem 10 equal to 4. Investment B is preferred over investment A since B provides higher expected utility.635 (the expected utility of investment B) and solve for the value of the first outcome in investment A: X 0. Chapter 10: Problem 11 To solve this problem.05X .
u 0.2 7 0.05 u 7 .
u 0.5 10 0.05 u 10 .
01X 2 2. Gruber.26 and 13.635 The equation above is a quadratic equation with two roots.26 (an increase). 6th Edition Solutions To Text Problems: Chapter 10 79 .275 1.5 X 2 20 X 86 0 4.74. So. the roots are found to be 6.u 0. the minimum amount that the first outcome of investment A would have to change by for the investor to be indifferent between investments A and B would be $6. since both investments would then provide the same level of expected utility.26 $5 = $1.3 2 2 2 4. Elton.2 X . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Using the quadratic formula.635 0.
6th Edition Solutions To Text Problems: Chapter 10 80 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.Elton.
Using secondorder stochastic dominance.0 0.0 0.0 0.1 2.5 0. Gruber.0 0.1 0.Elton.0 Prob(RC < 5%) = 0.9 No investment exhibits firstorder stochastic dominance. 6th Edition Solutions To Text Problems: Chapter 11 81 .0 1.0 0.2 0. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.2 0. and the investor would be indifferent to choosing either investment B or C.6 0.9 1.9 0.9 1. using Roy’s safetyfirst criterion. then for each investment in Problem 1 the maximum RL is: 3. C > B > A. B and C are preferred to A.0 Cumulative Cumulative Probability A B C 0. then for the investments in Problem 1 we have: Prob(RA < 5%) = 0.3 3.4 1.1 0.7 0.0 3.9 3.2 4. 6th Edition Solutions to Text Problems: Chapter 11 Chapter 11: Problem 1 Cumulative Probability A B C Outcome 4% 5% 6% 7% 8% 9% 10% 0. Chapter 11: Problem 2 Roy’s safetyfirst criterion is to minimize Prob(RP < RL).4 0.99% for A 5. but are indistinguishable from each other.5 0.9 1.0 4.5 1.4 2.99% for C Thus.0 0.0 0. investments B and C are preferred over investment A. Chapter 11: Problem 3 Kataoka's safetyfirst criterion is to maximize RL subject to Prob(RP < RL) d 1 D.1 2.2 0.9 0.0 0.2 0.2 Prob(RB < 5%) = 0.4 0.0 Thus. Elton.4 0.9 1.99% for B 5.0 2. If RL = 5%. If D = 10%.0 0.
1 0.8 0.6 1. Since these investments are ordered by firstorder stochastic dominance. the preference ordering is preserved under secondorder stochastic dominance. that for investment B. Project C has higher expected return (7.2 0. with investment B.78%) RGB = (1.0 1.0 0.0 1. Thus it is preferred using Telser’s criterion of maximizing Rp subject to the constraint. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. B is preferred to A under firstorder stochastic dominance (assuming investors prefer more to less). So the ordering is C > B > A.09%).0 0. we see that Project A in Problem 1 does not satisfy the constraint Prob(Rp d 5%) d 10%.0678 (6. the cumulative probability with investment A.9 1.08).3 (1. C > B > A.2 (1.3 (1. Gruber.0 0.08).3 0.1 = .3 0. Thus.Chapter 11: Problem 4 Employing Telser's criterion.08). Similarly.3 (1.07).1).0 0. the cumulative probability at any outcome is never greater than. Elton.4 (1.1 (1.1 0.0709 (7.1 = .06). C is preferred to B under firstorder stochastic dominance. Chapter 11: Problem 6 cumulative probability B C A 0. Chapter 11: Problem 5 The geometric mean returns of the investments shown in Problem 1 are: RGA = (1.1 0. 6th Edition Solutions To Text Problems: Chapter 11 82 .0 0.05).2 (1.9 0.2 (1.4 0.04).0 1. Between B and C.06). Thus it is eliminated.0 0.1 .1 . and is sometimes less than.99%) RGC = (1.3 (1.1 = .6 0.07).0 outcome 3% 4% 5% 6% 7% 8% 9% 10% 11% Since.1 .1% compared to 7%).6 1.4 0. since the cumulative probability associated with investment C is never greater than.06).0699 (6.4 (1.7 0.09).4 0.7 0. and is sometimes less than.1).
2 (1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.1). Prob(RA < 3%) = 0. So. Gruber.4 .2 (1.05).08).2 (1.04). and C are indistinguishable using Roy's criterion with RL = 3%. and Prob(RC < 3%) = 0.11).3 (1.4 .2 (1.1 = .0458 (4.28%) RGC = (1.03).0828 (8.1 (1. Chapter 11: Problem 8 The geometric mean returns of the investments shown in Problem 6 are: RGA = (1.1 (1.07).09). Prob(RB < 3%) = 0. C > B > A.58%) RGB = (1.1 = .08).98%).1 (1.05). Elton.Chapter 11: Problem 7 Roy's criterion is to minimize Prob(RP < RL).07).06).1 .1 = .1 (1.09).1 (1. When RL = 3%. B.4 (1.06).1 (1.09). 6th Edition Solutions To Text Problems: Chapter 11 83 . Thus.0898 (8. investments A.
Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 11 84 .Elton.
76 25. 6th Edition Solutions To Text Problems: Chapter 12 85 .646 Also. if the above inequality holds. 6th Edition Solutions to Text Problems: Chapter 12 Chapter 12: Problem 1 Equation (12. the above inequality does not hold. investor should consider those foreign markets as attractive investments.Elton.S.59 UN.US 0. then the foreign investment will be attractive to a U.K. we have: RN RF RUS RF VN Austria France Japan U.665 u U N. Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 24. Gruber.550 0. Given that RF = 6%.348 0. Gruber.S.577 V US 0.534 0..50 17.US For Austria and France.K.327 0. investor.281 0.K. 0.563 0. RUS and RN for the foreign countries are given in the problem's table.1) in the text can be used to answer this question: RN RF ! RUS RF u U N. so a U. from the text tables. for Japan and the U. the above inequality holds. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.358 0.311 0. From the tables in the text.59. VUS = 13. investor should not consider those foreign markets as attractive investments.70 15. we have: VN Austria France Japan U. so a U.289 0.US VN V US As is explained in the text.S.
X1.7.US = 0.Chapter 12: Problem 2 To answer this question.70 and UN. VUS = 13. use the formula introduced in Chapter 5 for finding the minimumrisk portfolio of two assets: GMV X1 2 V 2 V 1V 2 U12 2 V 12 V 2 2V 1V 2 U12 where X1 is the investment weight for asset 1 and X2 = 1 . VN = 16.423. For equities.59. So the minimumrisk portfolio is: GMV X US 16.
2 13.59.
16.7.
423.0.
59. 13.
2 16.7.
2 2.
13.59.
16.7.
423.0.
34% .6734 67. 0.
3266 32. GMV 1 X US GMV XN 0.66% .
45 and UN. VN = 9. So the minimumrisk portfolio is: GMV X US 9. VUS = 7.US = 0.45. For bonds.527.90.
2 7.9.
45.9.
527.0.
9. 7.
45.2 9.
2 2.
7.9.
45.9.
0.527.
41% .6841 68. 0.
GMV 1 X US GMV XN 0.3159 31.59% .
35.77. For Tbills.220. VUS = 0.US = 0. VN = 6. So the minimumrisk portfolio is: GMV X US 6.77 and UN.
35.2 0.
77.6.
22. 0.
0.35.
2 6.77.
2 2.
0.35.
6.77.
0.22.
63% . 0.9863 98.
GMV 1 X US GMV XN 0.37% .0137 1.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 12 86 . Gruber. Elton.
000 2.250 2/1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.76% Period 1 2 3 4 5 Average From U.0% 18.06) 1 1 1 1 1 = = = = = 32.750 2.75% 49.08) (1. So from the table in the problem we have: (1 + RX) (for US investor) 2.800 1.0% 19.5/2 = 0.667)(1. the return due to exchangerate changes (RX) is shown to be equal to fxt/fxt1 .15) (0.3% 36. These two rates are simply reciprocals.5 = 0.1) (1)(1.5 = 1.667 (1 + R*X) (for UK investor) 3/2.5 = 1. Let fxt be the exchange rate expressed in terms of dollars and fx*t be the exchange rate expressed in terms of pounds.73% 87 Elton.833 2.K.0% 83.05) (1)(0.1. the total return to a U.3% 7.S. Gruber.6)(1.6% From U.5/2. Investor Period 1 2 3 4 5 Average From U. So: Return to U.12) (0. Investment 10% 15% 5% 12% 6% 7.S.S.200 2.75)(1. 6th Edition Solutions To Text Problems: Chapter 12 . i.333 1.5/2.5/2.15) (1. Investor From U.4% 15.5/1.1) 1 1 1 1 1 = = = = = 12.000 2/2.S.600 Period 1 2 3 4 5 The total return to a U.5% 5.. Investment 5% 5% 15% 8% 10% 6.0% 8. investment is (1 + RX)(1 + RUK) 1.6% Return to U. investor from a U. Investment (0.5 = 1.95) (0.5/2 = 1. where fxt is the foreign exchange rate at time t expressed in terms of the investor's home currency per unit of foreign currency.0% 15.K. investment is(1 + R*X)(1 + RUS) 1.5 = 0. fx*t = 1/fxt.S.5 = 1. investor from a U. Investment (1.95) (1.5/3 = 0.K.333)(1.2)(1.K.K.25)(0.833)(1.8)(1.e.Chapter 12: Problem 3 In the text.5 = 1.
Investor V US 10 7.6.Chapter 12: Problem 4 Using the data and averages from Problem 3 we have: For U.S.
2 15 7.6.
6.2 5 7.
6.2 12 7.
2 6 7.6.
95% V UK 12.2 5 6.76.5 7.
76.2 5 7.
76.2 8 7.
76.2 19 7.
2 83.3 7.76.
06% For U.2 5 38.K. Investor V UK 5 6.6.
2 5 6.6.
2 15 6.6.
6.2 8 6.
6.2 10 6.
73.65% V US 32 15.2 5 6.
73.2 15 15.
73.2 18.75 15.
3 15.73.2 49.
2 36.4 15.73.
267 150/170 = 0. From the table in the problem we have: Period 1 2 3 4 5 (1 + RX) (for US investor) 200/180 = 1.900 190/180 = 1.111 180/190 = 0.944 (1 + R*X) (for Japanese investor) 180/200 = 0. Gruber.882 170/180 = 0.789 170/150 = 1. except that the exchange rate is given in indirect (yen/$) terms rather than direct ($/yen) terms.947 190/150 = 1.2 5 28.056 150/190 = 0.133 180/170 = 1.70% Chapter 12: Problem 5 This problem is essentially the same as Problem 3.059 Elton. 6th Edition Solutions To Text Problems: Chapter 12 88 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
947)(1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.111)(1.68% US For the Japanese investor: = 3.9)(1. Investor From U. investment is(1 + R*X)(1 + RUS) 1.059)(1. 6th Edition Solutions To Text Problems: Chapter 12 89 .44% 17.72%.37% 1.80% 21. Investment 12% 15% 5% 10% 6% 9.267)(1.227% Elton.12) (0. J J = 16.12) (1.16% 24. the total return to a Japanese investor from a U.18) (0.S.63% 12.26% Return to Japanese Investor Period 1 2 3 4 5 Average From Japan Investment 18% 12% 10% 12% 7% 11.6%.133)(1.05) (1. investor from a Japan investment is (1 + RX)(1 + RJ) 1.S.789)(1.1) (1.The total return to a U.S.S.25% 8.06) 1 1 1 1 1 = = = = = 0.056)(1.1) (0.S.39% Chapter 12: Problem 6 The answers to this problem are found in the same way as those to Problem 4.S.10% 6.8% From U.06% 39. investor: US = 3. = 15.22% 1.882)(1.01% 15.12) (1.15) (0. So: Return to U. Gruber.07) 1 1 1 1 1 = = = = = 31.6% Period 1 2 3 4 5 Average From Japan Investment (1.944)(1. For the U. Investment (0.
Chapter 12: Problem 7 Use the formula for the sample correlation coefficient U with five observations: U ¦ R 5 t 1 USt RUS R Jt R J .
.
.
2 ¦ R 5 t 1 USt RUS .
¦ R 2 5 t 1 Jt RJ For the U. U = 0. investor. U = 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.251.050. Gruber. 6th Edition Solutions To Text Problems: Chapter 12 90 . Elton. For the Japanese investor.S.
6th Edition Solutions to Text Problems: Chapter 13 Chapter 13: Problem 1 The equation for the security market line is: Ri RF Rm RF E i . Gruber.Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
from the data in the problem we have: 6 12 RF Rm RF u 0.5 for asset 2 .5 for asset 1 RF Rm RF u 1. Thus.
.
Using those values.04 0.04 0.5 0. an asset with a beta of 2 would have an expected return of: 3 + (9 3) u 2 = 15% Chapter 13: Problem 2 Given the security market line in this problem.08 8% . we find RF = 3% and Rm = 9%.08 u 2 0. Solving the above two equations simultaneously.08 u 0. for the two stocks to be fairly priced their expected returns must be: RX RY 0.
0.20 20% .
the two funds’ expected returns would be: RA RB 0. If the expected return on either stock is higher than its return given above.19 u 1.212 21.8 0.2% . Chapter 13: Problem 3 Given the security market line in this problem.2 0. the stock is a good buy.19 u 0.06 0.06 0.
288 28. 0.8% .
91 Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 13 . Gruber.
(The return on the market portfolio must therefore be 0. or 14%.14.) Chapter 13: Problem 5 The price form of the CAPM’s security market line equation is: Pi 1 rF ª cov Yi Ym .10 (10%). since their actual returns were below those expected given their beta risk.04 (4%).Comparing the above returns to the funds’ actual returns. the intercept of the line. we see that both funds performed poorly. Chapter 13: Problem 4 Given the security market line in this problem. the riskless rate equals 0.10 = 0.04 + 0. and the excess return of the market above the riskless rate (also called the “market risk premium”) equals 0. the slope of the line.
º «Yi Ym rF u Pm u » var Ym .
¼ ¬ .
where rF 1 RF .
and Rm Ym Pm . we have RF 0. Pm Ym Pm Pm From Problem 4. Substituting these vales into the above security market line equation.14Pm Ym . Therefore 0.04 and Rm 0.14 .14 which gives 1. we have: Pi cov Yi Ym .
º 1 ª » «Yi 1.04 u Pm .14 u Pm 1.
04 ¬ var Ym . u 1.
¼ cov Yi Ym .
º 1 ª «Yi 0.10 u Pm u » 1.04 ¬ var Ym .
¼ Elton. 6th Edition Solutions To Text Problems: Chapter 13 92 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
one should use the four KuhnTucker conditions shown in Appendix E of Chapter 6. setting dT 0 gives the equilibrium first order condition for asset i. we have. which is the standard dX i CAPM’s security market line: Ri or equivalently Ri RF Rm RF E i R F R m RF E i . To find the optimum portfolio when short sales are not allowed. for each asset i. given the assumptions of the standard CAPM.Chapter 13: Problem 6 To be rigorous. the following KuhnTucker conditions: dT Ui dX i 0 (1) X i Ui Xi t 0 0 (2) (3) (4) Ui t 0 We have already seen that.
.
0 When short sales are not allowed. KuhnTucker condition (1) implies that: Ri RF Rm RF E i Ui .
Xi > 0 for each asset and therefore. 0 But. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. the standard CAPM holds even if short sales are not allowed. Thus. given KuhnTucker condition (2). Elton. since all assets are held long in the market portfolio. Ui = 0 for each asset. 6th Edition Solutions To Text Problems: Chapter 13 93 .
3. Chapter 13: Problem 8 The security market line is: Ri R F R m RF E i .5)(1 – X1) = 1.5X1 + (1.7 The return on this combination would be: 0.8% with zero net investment and zero beta risk.3(6%) + 0. a portfolio with a beta of 1. buying asset 3 and financing it by shorting the portfolio would produce a positive (arbitrage) return of 15% 10. even though asset 1 and the portfolio have the same beta. X2 = 0.Chapter 13: Problem 7 Using the two assets in Problem 1.2 can be constructed as follows: 0.2% Asset 3 has a higher expected return than the portfolio of assets 1 and 2.2% = 4. Thus.7(12%) = 10.2 X1 = 0.
Substituting the given values for assets 1 and 2 gives two equations with two unknowns: 9.4 Solving simultaneously gives: RF R m RF u 0.3 .8 RF R m RF u 1.4 13.
.
178 17.8% . RF 3% . Rm 11% Chapter 13: Problem 9 Substituting the given betas in the given equation yields: R1 0.
151 15.1% . . R2 0.
Gruber. Elton. 6th Edition Solutions To Text Problems: Chapter 13 94 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
and the excess return of the market above the zerobeta portfolio’s return (also called the “market risk premium”) equals 0. or 14%. the intercept of the line.10 (10%). the slope of the line. referring back to the answer to Problem 5 in Chapter 13. 6th Edition Solutions to Text Problems: Chapter 14 Chapter 14: Problem 1 Given the zerobeta security market line in this problem. The return on the market portfolio must therefore be 0. the return on the zerobeta portfolio equals 0.10 = 0.Elton.04 (4%). Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. simply replace RF with RZ to obtain: Pi cov Yi Ym .14. Chapter 14: Problem 2 RZ has the same role in the zerobeta model as RF does in the standard model. Gruber.04 + 0. So.
º 1ª «Yi Ym rZ u Pm u » var Ym .
¼ rZ ¬ .
where rZ 1 R .
Z Chapter 14: Problem 3 As is shown in the text. the posttax form of the CAPM’s equilibrium pricing equation is: Ri RF Rm RF W u G m RF . .
u E i W u G i RF .
.
Rearranging the above equation to isolate Gi we have: Ri RF 1 W .
Rm RF W u G m RF .
u E i WG i .
Comparing the above general equation to the specific one given in the problem.05 we see that RF 1 W . 0.
0. or RF . and that W 0. Therefore: 1 W .24 .05 .
05 1 0.24. RF 0.
0.0658 6.58% .
6th Edition Solutions To Text Problems: Chapter 14 95 . Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.
where the efficient frontier extends along the ray from RF to the tangent portfolio L. The efficient frontier will therefore be a ray in expected returnstandard deviation space tangent to the minimumvariance curve of risky assets and intersecting the expected return axis at the riskless rate of 3% plus that part of the minimumvariance curve of risky assets to the right of the tangency point. This is depicted in the graph below. this situation is where there is riskless lending at RF and no riskless borrowing. Since both M and Z are on the minimumvariance curve. unless all investors in the economy choose to lend or invest solely in portfolio L. and since R Z > RF . Letting X be the investment weight for the market portfolio. the market portfolio M will always be on the minimumvariance curve to the right of portfolio L.Chapter 14: Problem 4 Since we are given R Z and only one RF . the expected return on any combination portfolio P of M and Z is: RP X R m 1 X . Note that. then to the right of L along the curve through the market portfolio M and out toward infinity (assuming unlimited short sales). the entire minimumvariance curve of risky assets can be traced out by using combinations (portfolios) of M and Z.
R Z (1) Recognizing that M and Z are uncorrelated. the standard deviation of any combination portfolio P of M and Z is: VP 2 2 X 2V m 1 X .
V Z 2 (2) Elton. 6th Edition Solutions To Text Problems: Chapter 14 96 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
Substituting the given values for R m and R Z into equation (1) gives: RP 15 X 51 X .
10 X 5 (3) Substituting the given values for V m and V Z into equation (2) gives: VP X 2 u 22 2 1 X .
24 44.2 7 7.0 15 1.72 The zerobeta form of the security market line describes equilibrium beta risk and expected return relationship for all securities and portfolios (including portfolio L) except those combination portfolios composed of the riskless asset and tangent portfolio L along the ray RF . u 8 2 2 484 X 2 64 128 X 64 X 2 548 X 2 128 X 64 (4) Using equations (3) and (4) and varying X (the fraction invested in the market portfolio M) gives various coordinates for the minimumvariance curve.0 25 VP 10.58 17.4 9 0.02 13.8 13 1.77 0.L in the above graph: Ri RZ Rm RZ E i 5 10 E i . some of them are given below: X RP 0 5 8 0.5 20 2.67 22 33.6 11 0.
L in the above graph is described by the following line: RC RF R L RF EL . The equilibrium beta risk and expected return relationship for any combination portfolio C composed of the riskless asset and tangent portfolio L along the ray RF .
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. 6th Edition Solutions To Text Problems: Chapter 14 97 .u E C Elton.
then: Ri RF R m RF G m RF .Combining the two lines yields the following graph: Chapter 14: Problem 5 If the posttax form of the equilibrium pricing model holds.
W E i G i RF .
W .
.
then: Ri RF R m RF E i . If the standard CAPM model holds.
Assume that the posttax model holds instead of the standard model. For a stock with G i RF . and G m RF .
Similarly. for a stock with G i RF .W ! 0 . the institution that uses the posttax model would correctly believe that the stock has a higher expected return than the stock’s return expected by the institution using the standard model.
Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 14 98 . Elton.W 0 . the institution that uses the posttax model would correctly believe the stock has a lower expected return than the stock’s return expected by the institution using the standard model.
25 If the posttax model holds.0 . W 0.Now consider a specific example using the following data for stocks A and B. E B 1. G B 0% . the market portfolio and the riskless asset: EA 1. G A 8% . R m 14% . then the institution using that model would correctly believe that the equilibrium expected returns for the two stocks are: RA 4 14 4 . RF 4% .0 . G m 4% .
4 4 .
u 0.25.
u 1.0 8 4 .
u 0.25 4 10 1 15% 4 14 4 .
4 4 .
u 0.25.
u 1.0 0 4 .
u 0.25 4 10 1 13% RB The institution using the standard model would incorrectly believe that the stocks’ equilibrium expected returns are: RA 4 14 4 .
0 4 10 14% 4 14 4 . u 1.
residual risk puts a limit to the amount of unbalancing the institution would do. Elton. But by some unbalancing. u 1. Gruber. The institution using the standard model would be indifferent between the two stocks. Of course. the institution earns an excess return. However.0 4 10 14% RB The institution using the posttax model would tend to buy stock A and sell stock B short. the institution loses excess return. by buying stock B. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 14 99 .
since the above orthogonality conditions (1). Gruber. by the force of arbitrage its expected return must also be zero: R ARB ¦X i ARB Ri i 0 (4) From a theorem of linear algebra.Chapter 14: Problem 6 Using Ross’s APT model. 6th Edition Solutions To Text Problems: Chapter 14 100 . R i can be expressed as a linear combination of 1. (2) and (3) with respect to the X iARB result in orthogonality condition (4) with respect to the X iARB . we can create an arbitrage portfolio as follows: ¦X i ARB i u1 0 ARB ai i (1) a ARB ¦X i 0 (2) b ARB ¦X i ARB bi i 0 (3) Since the above portfolio has zero net investment and zero risk with respect to the given twofactor model. ai and bi: Ri O0 u 1 O1ai O2 bi (5) We can create a zerorisk investment portfolio as follows: ¦X i Z i 1 aZ ¦X i Z i ai 0 bZ ¦X i Z i bi 0 Substituting the above equations into equation (5) gives: RZ ¦X i Z i Ri O0 ¦ X iZ O1 ¦ X iZ ai O2 ¦ X iZ bi i i i O0 Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
We can create a strictly marketrisk investment portfolio as follows: ¦X i M i 1 aM ¦X i i M i ai 1 bM ¦X ¦X i M i bi 0 Substituting the above equations into equation (5) gives: RM M i Ri O0 ¦ X iM O1 ¦ X iMai O2 ¦ X iMbi i i i O0 O1 or O1 R M O0 RM RZ We can create a strictly interest raterisk investment portfolio as follows: ¦X i C i 1 aC ¦X i C i ai 0 bC ¦X i C i bi 1 Substituting the above equations into equation (5) gives: RC ¦X i C i Ri O0 ¦ X iC O1 ¦ X iC ai O2 ¦ X iC bi i i i O0 O2 or O2 R C O0 RC RZ Substituting the derived values for O0. we have: Ri R Z R M R Z u ai R C R Z u bi . O1 and O2 into equation (5).
.
Gruber. Elton. 6th Edition Solutions To Text Problems: Chapter 14 101 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
since the market portfolio is a wealthweighted average of all the efficient riskyasset portfolios held by investors.Chapter 14: Problem 7 In the graph below. The expected return on a zerobeta asset is the intercept of a line tangent to the market portfolio. the riskfree lending rate must be below the expected return on a zerobeta asset. and no rational investor would hold a riskyasset portfolio along the curve to the left of L. Furthermore. the market portfolio M will be along the minimumvariance curve to the right of portfolio L. Furthermore. since the riskfree lending rate is the intercept of the line tangent to portfolio L. and the zerobeta portfolio on the minimumvariance frontier must be below the global minimum variance portfolio of risky assets by the geometry of the graph. unless all investors lend or invest solely in portfolio L. and since L is to the left of M on the minimumvariance curve. since no other portfolio offers a higher slope. the efficient frontier with riskless lending but no riskless borrowing is the ray extending from RF to the tangent portfolio L and then along the minimumvariance curve through the market portfolio M and out toward infinity (assuming unlimited short sales). Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. by the geometry of the graph. Elton. All investors who wish to lend will hold tangent portfolio L in some combination with the riskless asset. Gruber. 6th Edition Solutions To Text Problems: Chapter 14 102 .
Chapter 14: Problem 8 Assume the same situation as in Problem 5. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 14 103 . You expect a return before taxes of 15% on stock A and 13% on stock B. The investor who believes in the standard (pretax) CAPM expects a return of 14% on either security. Elton.25) then you should buy stock B from the other investor and sell that investor stock A. The expected returnbeta relationships of all risky securities riskyasset portfolios (including the market portfolio M and portfolio L) are described by that line. The fact that this will lead to higher aftertax cash flows for you is straightforward. Gruber. those combination portfolios are not described by the zerobeta security market line. The other line from the riskfree lending rate to portfolio L only describes the expected returnbeta relationships of combination portfolios of the riskfree asset and portfolio L.The zerobeta security market line is the line in the graph below extend from the expected return on a zerobeta asset through the market portfolio and out toward infinity (assuming unlimited short sales). If your tax factor was below the aggregate tax factor (W lower than 0.
Chapter 14: Problem 9 This problem can be answered directly by using the equation developed for nonmarketable assets. The equation also holds for deleted assets. with the subscript H now standing for those assets that were left out: Ri RF 2 Vm · § R m RF P u ¨ cov Ri Rm .
H cov Ri RH .
¸ ¸ ¨ P Pm ¹ H cov Rm RH .
this will offset the effect of positive correlation between all stocks and bonds and may actually result in a higher expected return for the stock. © Pm The effect of leaving out bonds depends on two factors: 1. 6th Edition Solutions To Text Problems: Chapter 14 104 . From the above equation. that will further lower the stock’s expected return. if the stock is positively correlated with bonds. If the return on a particular stock is negatively correlated with bonds. However. Elton.) The correlation between the returns on a particular stock and the returns on the aggregate of all bonds. 2. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.) Whether or not the returns on the aggregate of all bonds are negatively or positively correlated with the returns on the aggregate of all stocks. if returns on stocks and bonds are generally positively correlated (as empirical evidence shows). then the denominator in the second term of the equation will tend to lower the expected return on any stock.
Gruber. that highbeta stocks have higher expected (and over long periods of time higher actual) returns. 6th Edition Solutions to Text Problems: Chapter 15 Chapter 15: Problem 1 That is NOT a valid test of the theory. Then we have: R Ai RG RP RG u . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Chapter 15: Problem 2 Let: R Ai = the expected percentage change in alcoholism in city i.Elton. then they would be less risky than lowbeta stocks. R G = the expected percentage change in the price of gold. If highbeta stocks always gave higher returns. and hence sometimes below and sometimes above the returns on lowbeta stocks. It is precisely because the returns on highbeta stocks are more risky. R P = the expected percentage change in professors’ salaries. and the empirical evidence IS consistent with the theory.
cov R Ai RP .
var RP .
The above equation is exactly parallel to the zerobeta CAPM equation. The analogy between variables is seen from: Ri RZ Rm RZ u . with expected percentage change in alcoholism in a city playing the role of the expected return on a security.
cov Ri Rm .
var Rm .
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 15 105 . Gruber. Elton. tests exactly parallel to those employed in the text can be used. Therefore.
(This performance measure is known as “Jensen’s alpha” and is discussed at length in Chapter 24. If.7) in the text only holds for an efficient portfolio. if the market portfolio is inefficient the equality will not hold and instead we have: OV km z R k RF The remaining proof follows the proof shown in the text below equation (15.7). then the real relationship as a crosssectional regression model is: R i RF J 0 J 1E i J 2 G i RF .) Chapter 15: Problem 5 If the posttax form of the CAPM holds. it would indicate superior performance. Chapter 15: Problem 4 One way to use general equilibrium theory to evaluate a stock portfolio manager’s performance would be to estimate the equilibrium security market line using historical time series of returns over a period of time along with the portfolio’s average return and beta. but with the notequal sign replacing the equal sign in all the remaining equations in the proof. given the portfolio’s beta.Chapter 15: Problem 3 Since the equality shown in equation (15. the portfolio had an average return above the equilibrium return predicted by the estimated security market line.
empirical evidence shows that G and E are negatively correlated across securities (highdividend securities tend to have low betas and lowdividend securities tend to have high betas) and that G is positively correlated with R across securities. Elton. The effect of the bias is to raise the estimate of the intercept (J0) and lower the estimate of the slope (J1). then the regression estimates of J0 and J1 in the standard model would be unaffected. However. so this is a classic case of missingvariable bias. the crosssectional regression model is: R i RF J 0 J 1E i H i If G was uncorrelated with E across securities. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. H i If the standard CAPM security market line is tested. 6th Edition Solutions To Text Problems: Chapter 15 106 . Gruber.
5O2 (a) (b) (c) 13.4 2O1 0.6 or O1 1 and O 2 12 1 Substitute O1 2 into equation (a): O0 1 1 or O0 10 Thus. O1 and O2. 6th Edition Solutions to Text Problems: Chapter 16 Chapter 16: Problem 1 From the text we know that three points determine a plane. Gruber. One method is shown below.4 0. 6th Edition Solutions To Text Problems: Chapter 16 107 . Gruber. the equation of the equilibrium APT plane is: Ri 10 bi1 2bi 2 Elton.Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. There are many ways to solve a set of simultaneous linear equations.3O 2 Subtract equation (a) from equation (c): 0 2O1 O2 Subtract equation (e) from equation (d): 1.4 2O1 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. The APT equation for a plane is: R i O 0 O1bi1 O2 bi 2 Assuming that the three portfolios given in the problem are in equilibrium (on the plane).7O 2 or O 2 2 Substitute O2 (d) (e) 2 into equation (d): 1.2O2 O0 3O1 0.5O2 The above set of linear equations can be solved simultaneously for the three unknown values of O0.4 12 O0 3O1 0. then their expected returns are determined by: 12 O0 O1 0. Subtract equation (a) from equation (b): 1.
any security with b1 = 2 and b2 = 0 should have an equilibrium expected return of 12%: Ri 10 bi1 2bi 2 10 2 2 u 0 12% Assuming the derived equilibrium APT plane holds.Chapter 16: Problem 2 According to the equilibrium APT plane derived in Problem 1. the portfolio is not in equilibrium and an arbitrage opportunity exists. that has the same factor loadings (risk) as portfolio D. call it portfolio E. since portfolio D has bD1 = 2 and bD2 = 0 with an expected return of 10%. B and C in Problem 1 and recalling that an investment portfolio’s weights sum to 1 and that a portfolio’s factor loadings are weighted averages of the individual factor loadings we have: bE1 bE 2 X A b A1 X B bB1 1 X A X B . Using the equilibrium portfolios A. The first step is to use portfolios in equilibrium to create a replicating equilibrium investment portfolio.
bC1 X A b A2 X B bB 2 1 X A X B .
bC2 1X A 3 X B 31 X A X B .
51 X A X B .2 X B 0.5 X A 0. bD1 2 b D2 0 0.
We have seen above that any security with portfolio E’s factor loadings has an equilibrium expected return of 12%. 6th Edition Solutions To Text Problems: Chapter 16 108 . combining the two portfolios by going long in one and shorting the other. Gruber. This will create a selffinancing (zero net investment) portfolio with zero risk: an arbitrage portfolio. Simplifying the above two equations. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.7 X B 1 . Elton. Since they have the same risk (factor loadings). we can create an arbitrage portfolio. portfolio E is also on the equilibrium plane.4 u 12 12% 2 2 So now we have two portfolios with exactly the same risk: the target portfolio D and the equilibrium replicating portfolio E. 2 Since portfolio E was constructed from equilibrium portfolios. and that is the expected return of portfolio E: RE X A R A X B RB X C RC 1 1 u 12 0 u 13. we have: 2X A 1 or X A 1 2 1 2 X A 0. XB 2 Since X A 0 and X C 1 X A X B 1 .
since the arbitrage with portfolio D can be accomplished using other assets on the equilibrium APT plane. thereby pushing portfolio D’s expected return up until it reaches its equilibrium level of 12%. This gives us: ¦X i ARB i ARB ARB XE XD 1 1 0 (zero net investment) But since portfolio E consists of a weighted average of portfolios A.5 0 u 0. neither is the arbitrage portfolio containing D and E. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. so we have: 2 2 ¦X i ARB i ARB ARB ARB ARB X A XB XC XD 1 1 0 1 0 (zero net investment) 2 2 b ARB1 ¦X i ARB bi1 i ARB ARB ARB ARB X A b A1 X B bB1 X C bC1 X D bD1 1 1 u 1 0 u 3 u 3 1u 2 2 2 0 b ARB 2 (zero factor 1 risk) ¦X i ARB bi 2 i ARB ARB ARB ARB X A b A2 X B b B 2 X C bC 2 X D b D2 1 1 u 0. 6th Edition Solutions To Text Problems: Chapter 16 109 .In equilibrium. B and C. Gruber. we want to go long in E and short D. We need to short sell either portfolio D or E and go long in the other. B and C. the price of portfolio D will drop.2 u 0. There is no reason to expect any price effects on portfolios A. we want X E 1 and X D 1. an arbitrage portfolio has an expected return of zero. but since portfolio D is not in equilibrium. 1 1 ARB ARB ARB ARB 1 is the same thing as X A XE .4 u 12 1u 10 2 2 2% (positive arbitrage return) As arbitrageurs exploit the opportunity by short selling portfolio D. The question is: which portfolio do we short and which do we go long in? Since both portfolios have the same risk and since portfolio E has a higher expected return than portfolio D. Elton. XB 0 and X C . at which point the expected return on the arbitrage portfolio will equal 0. in ARB ARB other words.5 1u 0 2 2 0 R ARB (zero factor 2 risk) ¦X i ARB Ri i ARB ARB ARB ARB X A R A X B RB XC RC X D RD 1 1 u 12 0 u 13. and an arbitrage profit may be made.
O2 2 .5O1 3O2 Solving for the three unknowns in the same way as in Problem 1. Using the equilibrium portfolios A. that has the same factor loadings (risk) as portfolio D. since portfolio D has bD1 = 1 and bD2 = 0 with an expected return of 15%. the portfolio is not in equilibrium and an arbitrage opportunity exists. then their expected returns are determined by: 12 O0 O1 O2 (a) (b) (c) 13 17 O0 1. the equation of the equilibrium APT plane is: Ri 8 6bi1 2bi 2 Chapter 16: Problem 4 According to the equilibrium APT plane derived in Problem 3.Chapter 16: Problem 3 From the text we know that three points determine a plane. call it portfolio E. we obtain the following solution to the above set of simultaneous linear equations: O0 8 . The APT equation for a plane is: R i O 0 O1bi1 O2 bi 2 Assuming that the three portfolios given in the problem are in equilibrium (on the plane). any security with b1 = 1 and b2 = 0 should have an equilibrium expected return of 12%: Ri 8 6bi1 2bi 2 8 6 2u0 14% Assuming the derived equilibrium APT plane holds. O1 6 . The first step is to use portfolios in equilibrium to create a replicating equilibrium investment portfolio.5O1 2O2 O 0 0. Thus. B and C in Problem 3 and recalling that an investment portfolio’s weights sum to 1 and that a portfolio’s factor loadings are weighted averages of the individual factor loadings we have: bE1 bE 2 X A b A1 X B bB1 1 X A X B .
bC1 X A b A2 X B bB 2 1 X A X B .
51 X A X B .5 X B 0. bC2 1X A 1.
X A 2 X B 31 X A X B .
bD1 b D2 0 110 1 Elton. Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 16 .
portfolio E is also on the equilibrium plane. 3 Since portfolio E was constructed from equilibrium portfolios. but since portfolio D is not in equilibrium.Simplifying the above two equations. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. We need to short sell either portfolio D or E and go long in the other. Gruber. neither is the arbitrage portfolio containing D and E. 6th Edition Solutions To Text Problems: Chapter 16 111 . This will create a selffinancing (zero net investment) portfolio with zero risk: an arbitrage portfolio. and an arbitrage profit may be made. we have: 1 XA XB 2 1 2 4X A 5X B 3 Solving the above two simultaneous equations we have: XA 1 . The question is: which portfolio do we short and which do we go long in? Since both portfolios have the same risk and since portfolio D has a higher expected return than ARB 1 portfolio E. We have seen above that any security with portfolio E’s factor loadings has an equilibrium expected return of 14%. we want X D ARB and X E 1. an arbitrage portfolio has an expected return of zero. Since they have the same risk (factor loadings). combining the two portfolios by going long in one and shorting the other. In equilibrium. in other words. This gives us: ¦X i ARB i ARB ARB XD XE 1 1 0 (zero net investment) Elton. we want to go long in D and short E. XB 3 1 and X C 3 1 X A X B 1 . we can create an arbitrage portfolio. and that is the expected return of portfolio E: RE X A R A X B RB XC RC 1 1 1 u 12 u 13 u 17 14% 3 3 3 So now we have two portfolios with exactly the same risk: the target portfolio D and the equilibrium replicating portfolio E.
Gruber. since the arbitrage with portfolio D can be accomplished using other assets on the equilibrium APT plane. so we have: XE 1 is the same thing as X A 3 3 3 ¦X i ARB i ARB ARB ARB ARB X A XB XC XD 1 1 1 1 0 (zero net investment) 3 3 3 b ARB1 ¦X i ARB bi1 i ARB ARB A ARB X A b A1 X B bB1 X CRB bC1 X D bD1 1 1 1 u 1 u 1. if it exists. B and C. 1 1 1 ARB ARB ARB ARB . XB and X C . Chapter 16: Problem 5 The general Kfactor APT equation for expected return is: Ri O0 ¦ O k bik k 1 K where O0 is the return on the riskless asset. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.5 u 0. B and C. There is no reason to expect any price effects on portfolios A. 6th Edition Solutions To Text Problems: Chapter 16 . at which point the expected return on the arbitrage portfolio will equal 0. 112 Elton. the price of portfolio D will rise.But since portfolio E consists of a weighted average of portfolios A.5 1u 1 3 3 3 0 (zero factor 1 risk) b ARB 2 ¦X i ARB bi 2 i ARB ARB ARB ARB X A b A2 X B b B 2 X C bC 2 X D b D2 1 1 1 u 1 u 2 u 3 1u 0 3 3 3 0 R ARB (zero factor 2 risk) ¦X i ARB Ri i ARB ARB ARB ARB X A R A X B R B XC RC X D RD 1 1 1 u 12 u 13 u 17 1u 15 3 3 3 1% (positive arbitrage return) As arbitrageurs exploit the opportunity by buying portfolio D. thereby pushing portfolio D’s expected return down until it reaches its equilibrium level of 14%.
12 u 0.24 u 6 5. along with a riskless rate of 8%.56 u 0. Chapter 16: Problem 6 A. for a 2factor APT model to be consistent with the standard CAPM. Given that R m RF 4 and using results from . O j R m RF E Oj .36 u 1.59. 1.Given the data in the problem and in Table 16. enters because the stock is a construction stock.59 10.4 0.1 in the text. From the text we know that. the Sharpe multifactor model for the expected return on a stock in the construction industry is: Ri 8 5.2 0.2 2 u 1 1.034% The last number.
.
2 4 E O 2 or E O 2 0.5 3 u 0.5 C. Problem 1. we have: 1 4 E O1 or E O1 B. bi1E O1 bi 2 E O 2 .25 0. For example. Assuming all three portfolios in Problem 1 are in equilibrium.25 0.5 u 0.2 u 0. From the text we know that E i 0. So we have: EA 1u 0.5 0.5 u 0.5 0.5 . using portfolio A gives: RA Rf R m RF E A or RF .25 0. then we can use any one of them to find the riskfree rate.85 0.25 .5 EB EC 3 u 0.
R A R m RF E A .
E A 0. Given that R A 12% .5 and R m RF RF .
6th Edition Solutions To Text Problems: Chapter 16 113 .5 10% Elton. we have: 12 4 u 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. 4% .
6th Edition Solutions To Text Problems: Chapter 16 114 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.Elton.
select the X percent (e.g. riskadjusted excess returns for the final group could be obtained and examined using one of the methodologies outlined in the text.Elton. Gruber. Either the beta or standard deviation of this portfolio could be used as a risk measure. the efficient market hypothesis says that prices should reflect all publicly available information. then select from that group the Y percent (e. Chapter 17: Problem 2 See the section in the text entitled “Relative Strength” for the answer to this question. In testing this strategy. If you have access to a “good” and significant piece of information that you believe is not yet public information. Chapter 17: Problem 3 There are several ways this rule could be tested.. in examining returns from this strategy. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. indicating whether or not the market had already incorporated that information. 6th Edition Solutions To Text Problems: Chapter 17 114 . Naturally. Gruber. The results of Davies and Canes suggest that roundtrip transactions costs must be less than two percent and perhaps less than one percent for this rule to produce excess returns. 20%) with the largest fiveyear growth rates. you could examine the residuals from a model such as the “market model” to see if there were recently positive excess returns. Chapter 17: Problem 4 If a market is semistrongform efficient.g. 6th Edition Solutions to Text Problems: Chapter 17 Chapter 17: Problem 1 The simplest trading strategy would be to buy a stock at the opening price on the day that the “heard on the street” column indicates analysts have reported positive recommendations and to short sell it if analysts have reported negative recommendations. purchases and sales would have to be adjusted for transactions costs. Elton. the stock position could be unwound after five days. Following this strategy will lead to a changing portfolio of stocks being held over time. After then making sure that transactions costs are included. we would have to be sure to adjust the returns for risk.. 20%) of the stocks with the lowest P/E ratios. Since any stock price effect occurs very shortly after the news is released. One way would be to rank all stocks by their P/E ratios. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
Elton. you could test that by following any of the test methodologies outlined in the text for semistrongform efficiency. Chapter 17: Problem 9 As in Problem 6. The only rational explanation for weakform inefficiency is if information is incorporated into prices slowly over time. If we were testing a phenomenon that tended to occur for lowbeta stocks and not for highbeta stocks. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. The only exception to this might be if the market is strongform inefficient and monopoly access to information disseminates through widening circles of investors over time. Chapter 17: Problem 7 Recall that the zerobeta CAPM leads to lower expected returns for highbeta (above 1) stocks and higher expected returns for lowbeta stocks than does the standard CAPM. Since the house does not change the odds (prices) to reflect an unbalanced roulette wheel. Gruber. where day zero (the “event day”) could be defined either as the day of retirement or as the day the retirement is first announced to the public. there is no way that that information can be used to change the expected return. then the zerobeta CAPM could show inefficiency while the standard CAPM showed efficiency. thus causing returns to be positively autocorrelated. 6th Edition Solutions To Text Problems: Chapter 17 115 . Chapter 17: Problem 8 The betting market at roulette is in general an efficient market.Chapter 17: Problem 5 If a market is semistrongform efficient. the efficient market hypothesis says that prices should reflect all publicly available information. one would strongly suspect the market to be weakform efficient as well. The only exception to this might be if the roulette wheel was not perfectly balanced. Chapter 17: Problem 6 You could test that by following any of the test methodologies outlined in the text for semistrongform efficiency. an unbalanced wheel would make the betting market at roulette inefficient. If publicly available information is already fully reflected in market prices. where day zero (the “event day”) is defined as the day at which the block of stocks becomes available for trading. Though betting on the roulette wheel has a negative expected return.
Elton. 6th Edition Solutions To Text Problems: Chapter 17 116 . Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions to Text Problems: Chapter 18 Chapter 18: Problem 1 Since the company’s growth rate of 10% extends into the future indefinitely.Elton. use the constantgrowth model to value its stock: P0 D1 kg D0 1 g. Gruber.
13 Chapter 18: Problem 2 Using equation (18.5b) in the text for k (the required rate of return) we have: k D1 rb P0 1 0.103 10.12 0.3% . kg 0.14 0. we have: P0 D1 k rb 1 0.5b) in the text.1 0.00 Chapter 18: Problem 3 Solving equation (18.10 $15.5 30 0.55 u 1.5 $20.14 u 0.14 u 0.
5b) in the text for r (the rate of return on new investment) we have: § D · 1 § 1· 1 r ¨k 1 ¸ u 0. Chapter 18: Problem 4 Solving equation (18.207 20.7% .
12 ¸u ¨ 60 ¹ 0. an increase of 6. ¨ 0.7%. 6th Edition Solutions To Text Problems: Chapter 18 117 .5 P0 ¸ b © ¹ © So the rate of return on new investment would have to change from 14% to 20. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Elton. Gruber.7 percentage points.
where the first growth period is 5 years with a growth rate of 10% (g1) followed by a growth rate of 6% (g2) indefinitely: P0 ¦ 1 k.Chapter 18: Problem 5 This problem can be solved using the twoperiod growth model shown in the text.
t 1 5 D11 g1 .
t t 1 1 k .
5 P5 ¦ 1 k.
t 1 5 D11 g1 .
t t 1 § D6 · ¨ ¸ ¨kg ¸ 2 ¹ © 1 k .
5 ª § 1 g · 5 º § D6 · 1 «1 ¨ ¸ ¨ ¨ 1 k ¸ » ¨ k g ¸ ¸ « 2 ¹ ¹ »© D1 « © k g1 » 1 k .
5 « » « » ¬ ¼ ª § 1 g · 5 º § D6 · 1 «1 ¨ ¸ ¨ 1 k ¸ » ¨ k g ¸ ¸ ¨ « 2 ¹ ¹ »© D0 1 g1 .
« © k g1 » 1 k .
5/0.3 to reflect the increased dividend payout rate. we have: D6 D5 1 g2 .5 « » « » ¬ ¼ Recognizing that the dividend at the end of period 6 is equal to the dividend at the end of period 5 compounded 1 period at g2 and then adjusted by a factor of 0.
5 0.3 0.5 5 0.1.3 0. u 5 0.5 0.55 u 1.
565 D0 1 g1 .06 u 0. u 1.3 $1.
1 g2 .
Gruber. u Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 18 118 .
14 0.14.1 · 5 º § 1.1u « 0.55 u 1.565 · « 1 ¨ ¸ ¸ » ¨ « © 1.So we have: ª § 1.06 ¹ 0.14 ¹ » © 0.14 0.10 » 1.
64 P0 Chapter 18: Problem 6 This problem can be solved using the threeperiod growth model shown in the text. g3 = 8. g4 and g5) over a second period of 4 years down to a 6% steadystate growth rate (gs) indefinitely thereafter.474 10. g5 = 6.5 » « » « ¼ ¬ 0. Since the growth rate is declining linearly over the 4year period.163 $12. and the model is: ª § 1 g · 5 º 1 «1 ¨ ¨ 1 k ¸ » 9 D ¸ P9 « ¹ » t D1 « © » t k g1 1 k .16355 19. So we have g1 = 10% (first 5 decline is 5 years).04 1.925 2. g4 = 7.2% (year 6).8 percentage points per year. g3.605 u 0.6% (year 8).563 0. where the first growth period is 5 years with a growth rate of 10% (g1) followed each year by linearly declining growth rates (g2. the annual 10 6 0.4% (year 7).8% (year 9) and gS = 6% (year 10 and thereafter). g2 = 9.
9 « » t 6 1 k .
« » ¬ ¼ 5 t 4 ª § 1 g · º 1 1 g j .
§ D10 · ¨ » 9 D5 «1 ¨ ¨ ¸ ¸ ¨kg ¸ ¸ j 2 « © 1 k ¹ » S ¹ © D1 « k g1 » t 6 1 k .
t 1 k .
9 » « » « ¼ ¬ t 4 ª § 1 g · 5 º 5 1 1 g j .
«1 ¨ » 9 D0 1 g1 .
¨ ¸ ¸ j 2 « © 1 k ¹ » D0 1 g1 .
« k g1 » t 6 1 k .
t « » « » ¬ ¼ P0 ¦ ¦ ¦ § D10 · ¨ ¸ ¨kg ¸ S ¹ © 1 k .
Gruber.9 Elton. 6th Edition Solutions To Text Problems: Chapter 18 119 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
3 to reflect the increased dividend payout rate.Recognizing that the dividend at the end of period 10 is equal to the dividend at the end of period 9 compounded 1 period at gS and then adjusted by a factor of 0.5/0. we have: D10 D9 1 g S .
3 0.5 0. u 5 0.5 1 g .
u 1 g .
u 0.3 j S j 2 5 D0 1 g1 .
u 5 0.55 u 1.1.
u 1.068 u 1.092 u 1.084 u 1.3 P0 t 4 ª § 1 g · 5 º 5 1 1 g j .5 0.129 So we have: 0.06 u $2.076 u 1.
§ D10 · D0 1 g1 .
¨ «1 ¨ ¸ ¨kg ¸ ¨ 1 k ¸ » 9 ¸ j 2 « © 6 ¹ ¹ » D0 1 g1 .
« © k g1 » t 6 1 k .
t 1 k .
1 · º « 1 ¨ ¸ » 5 5 « © 1.14 ¹ » 0.9 » « » « ¼ ¬ 5 ª § 1.55 u 1.1.
092 0. u 1.55 u 1.1.
084 0. u 1.092 u 1.14 0.10 » 1.1u « 0.55 u 1.14.
14.6 1.
55 u 1.1.7 » « » « ¼ ¬ ¦ 0.
092 u 1.076 5 1.084 u 1.14. u 1.
8 0.55 u 1.1.
076 u 1.084 u 1.14. u 1.068 5 1.092 u 1.
14.14 0.06 ¹ © 1.9 § 2.129 · ¨ ¸ 0.
441 0.5b) in the text for k (the expected rate of return) we have: k D1 rb P0 1 0.396 0.9 2.1% .181 18.419 0.5 9 0.474 0.184 $12.29 Chapter 18: Problem 7 Solving equation (18.371 8.14 u 0.
Elton. 6th Edition Solutions To Text Problems: Chapter 18 120 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.
use the equation (18.Chapter 18: Problem 8 Since the company’s growth rate of 10% extends into the future indefinitely.6) in the text from the constantgrowth model: k D1 g P0 D0 1 g.
1 0.167 16. g P0 0.55 u 1.7% .1 9 0.
where the first growth period is 10 years with a growth rate of rb = g1 followed by a growth rate of 5% (g2) indefinitely. The model is: ª § 1 g ·10 º 1 «1 ¨ ¨ 1 k ¸ » ¸ « ¹ » D1 u « © » k g1 « » « » ¬ ¼ § D11 · ¨ ¨kg ¸ ¸ 2 ¹ © 1 k . Chapter 18: Problem 9 This problem can be solved using the twoperiod growth model shown in the text.
14 u 0.14 and b = 0.5. Also.10 P0 Given r = 0.5 = 0. g1 = 0. D11 D10 1 g2 .07 (7%).
07. 9 9 1u 1.
93 So we have: D11 g1 .05 $1. u 1.
1 g2 .
12.07 » 1.12 ¹ » © 0.07 ·10 º § 1.12 0.05 ¹ 1u « 0.12 0.93 · «1 ¨ ¸ » ¨ ¸ « © 1. P0 ª § 1.
6th Edition Solutions To Text Problems: Chapter 18 121 .21 Elton.10 « » « » ¬ ¼ 7. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.88 $16. Gruber.33 8.
By trial and error the solution is k = 9.6%. Chapter 18: Problem 11 As with Problem 10. Chapter 18: Problem 12 The solution to this problem is a general form of the model shown in the answer to Problem 6: P0 ª § 1 g · N1 º 1 «1 ¨ ¸ ¨ 1 k ¸ » N1 N2 § D · « ¹ » t ¨ ¸ PN1 N2 D0 1 g1 . By trial and error the solution is 24 years. this problem can be solved iteratively by substituting various values for the length of the first growth period into the first formula shown in the answer for Problem 9.Chapter 18: Problem 10 This problem can be solved iteratively by substituting various values for k into the first formula shown in the answer for Problem 9.
u « © » N1 N2 t ¸ ¨ k g1 » t N11© 1 k .
¹ 1 k .
« » « ¼ ¬ N2 N1 § ª § 1 g · º § g gS .
· · § DN1 N2 1 · N1 1 ¸ ¸¸ ¨ ¨1 g1 j u 1 «1 ¨ ¸ » N1 N2 ¨ D0 1 g1 .
¨ ¨ 1 k ¸ ¨ N2 1.
¸ ¸ ¨ k gS ¸ ¹ j 1 © « ¹ © ¹ » D0 1 g1 .
u « © ¸ ¨ » t N1 N2 k g1 1 k .
¸ 1 k .
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Elton. 6th Edition Solutions To Text Problems: Chapter 18 122 . Gruber. » t N11¨ « ¸ ¨ » « ¼ ¬ ¹ © ¦ ¦ where D0 = the justpaid dividend g1 = the annual growth rate during the first period of years N1 = the number of years in the first growth period N2 = the number of years in the second growth period of linearly changing growth rates gS = the annual steadystate growth rate after the second period of linearly changing growth rates Note that the step value for linearly changing rates from g1 to gS is (g1 gS) / (N2 + 1). not (g1 gS) / N2.
A. 6th Edition Solutions to Text Problems: Chapter 19 Chapter 19: Problem 1 If earnings follow a meanreverting process. the following exponential smoothing model could be used to forecast future earnings: ˆ Et where ˆ Et 1 a Et Et 1 . Gruber. If earnings follow a meanreverting process with no trend or cycle. There are many appropriate techniques.Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. then it is appropriate to use historical data to forecast future earnings. Three specific ones are presented below.
with an additive trend the forecast would be: ˆ ˆ E t gt where ˆ Et ˆ E t 1 ˆ ˆ ˆ gt 1 a Et Et 1 gt 1 . either smoothed earnings plus the trend or smoothed earnings times the trend could be used. . ˆ Et = the timet forecast for earnings at time t + 1. For example. depending on whether the trend was additive or multiplicative.0. If earnings follow a meanreverting process with a trend but no cycle. Et = the actual earnings at time t. B. a = a constant less than 1.
> .
For example. C. with an additive trend and a multiplicative cycle the forecast would be: ˆ E t ˆ gt u ˆ ft . See footnote 7 in the text for further details on this technique. then the forecast is smoothed earnings adjusted for the trend and the cycle.@ ˆ gt is the timet estimate of the trend. If earnings follow a meanreverting process with a trend and a cycle.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. 6th Edition Solutions To Text Problems: Chapter 19 123 . Elton. ft where ˆ is the timet estimate of the cycle.
Mean reversion could be present in the industry’s and economy’s earnings. Chapter 19: Problem 5 If earnings expectations are important in determining share prices. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. then a valuable analyst is one who can forecast changes in investors’ expectations.Chapter 19: Problem 2 If there was a strong relationship between a firm’s earnings and the overall industry’s and economy’s earnings. a linear model could be estimated: Ei a bE I cE E where Ei = the firm i’s earnings. Such an equation switches the forecasting task from forecasting Ei directly to forecasting it indirectly by first forecasting EI and EE and estimating the parameters a. Elton. too. If forecasts in general become more accurate over time. then. a valuable analyst is one who at any point in time can forecast more accurately than the average analyst can. EI = the industry’s earnings. 6th Edition Solutions To Text Problems: Chapter 19 124 . Chapter 19: Problem 3 YES. EE = the economy’s earnings. Gruber. for example. Chapter 19: Problem 4 YES. The economy could also exhibit independence in earnings changes. b and c.
(Note that these are not investment weights that sum to 1. if the Law of One Price held.080 YB = $1.) Then we have: t = 1: t = 2: $100 YA + $80 YB = $90 $1. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. So buying 1/2 of bond A and 1/2 of bond B gives the same cash flows as buying 1 bond C (or. Let YA be the fraction of bond A purchased and YB be the fraction of bond B purchased.Elton. since we are given that PA = $970. equivalently. 6th Edition Solutions to Text Problems: Chapter 20 Chapter 20: Problem 1 We can use the cash flows bonds A and B to replicate the cash flows of bond C. PB = $936 and PC = $980. so we have: Current Yield = $100 y $960 = 0.1042 (10. we have instead: 1/2 u $970 + 1/2 u $936 = $953 < $980 The Law of One Price does not hold. Given that the future cash flows of the portfolio of bonds A and B are identical in timing and amount to those of bond C. buying 1 bond A and 1 bond B gives the same cash flows as buying 2 of bond C). Therefore. A bond’s current yield is simply its annual interest payment divided by its current price.100 YA + $1. 6th Edition Solutions To Text Problems: Chapter 20 125 . Gruber.42%) Elton. Gruber. Chapter 20: Problem 2 A. the bonds’ current prices would be related as follows: 1/2 PA + 1/2 PB = PC But.090 Solving the above two equations simultaneously gives YA= YB = 1/2. an investor should purchase 1 bond A and 1 bond B rather than 2 of bond C. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. and assuming that all three bonds are in the same risk class.
that solves the following equation: 5 § · ¨ $100 ¸ $1000 $960 t ¸ ¨1 1 y . A bond’s yield to maturity is the discount rate that makes the sum of the present values of the bond’s future cash flows equal to the bond’s current price. y. Since this bond has annual cash flows. we need to find the rate.B.
5 t 1 © y.
Elton. compute I to get I = y = 11. Gruber.08%. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. The zerocoupon bonds in this problem all have face values equal to $1. the nominally annualized spot rate for period t (S0t) is the yield to maturity for a tperiod zerocoupon (pure discount) instrument: P0 F § S0t · ¨1 ¸ 2 ¹ © t where P0 is the zero’s current market price. Chapter 20: Problem 3 In general. and t is the number of semiannual periods left until the zero matures. 6th Edition Solutions To Text Problems: Chapter 20 126 . F is the zero’s face (par) value. ¹ ¦ We can find y iteratively by trial and error.000. but the easiest way is to use a financial calculator and input the following: PV = 960 PMT = 100 FV = 1000 N=5 After entering the above data.
31%) 855 = 4 S04 0.99%) The nominally annualized implied forward rates (ft.t+j) can be obtained from the above spot rates. then bond A is a oneperiod zero. bond B is a twoperiod (oneyear) zero.0799 (7. bond C is a threeperiod zero. and bond D is a fourperiod (twoyear) zero.t ¨ «¨ ¨ 2 © © « ¬ t j 1 º ·j » ¸ » ¸ ¸ 1» u 2 » ¸ » ¸ » ¸ ¹ » ¼ ft .33%) 920 = 885 = § S 02 · ¨1 ¸ ¨ 2 ¸ © ¹ 1000 § S 03 · ¸ ¨1 ¨ 2 ¸ ¹ © 1000 § S 04 ¨1 ¨ 2 © · ¸ ¸ ¹ 2 S02 0.t j ¨ «¨ ¨1 ¨ 2 «¨ © «¨ «¨ §1 S0. So we have: 960 1000 § S 01 · ¸ ¨1 ¨ 2 ¸ ¹ © 1000 1 S 01 0. 6th Edition Solutions To Text Problems: Chapter 20 127 . Elton. and both t and j are integers greater than 0.0851 (8.51%) 3 S03 0.0831 (8. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0833 (8. A general expression for the relationship between current spot rates and implied forward rates is: ª «§ § S0. Gruber.If semiannual periods are assumed. j is the number of semiannual periods spanned by the forward rate.t j · ¸ ¸ ¹ · ¸ ¸ ¹ t where t is the semiannual period at the end of which the forward rate begins.
0426.We can an obtain a set of oneperiod forward rates by setting j equal to 1 and varying t from 1 to 3 in the preceding equation: ª§ § S · 2 «¨ ¨1 02 ¸ 2 ¸ «¨ ¨ ¹ © «¨ 1 «¨ §1 S01 · ¸ ¨ «¨ ¨ 2 ¸ ¹ ¬© © ª§ § «¨ ¨1 «¨ ¨ © «¨ «¨ §1 ¨ «¨ ¨ ¬© © ª§ § «¨ ¨1 «¨ ¨ © «¨ «¨ §1 ¨ «¨ ¨ ¬© © S03 2 S02 2 S04 2 S03 2 · º ¸ » ¸ » ¸ 1» u 2 ¸ » ¸ » ¹ ¼ 3 · · º ¸ ¸ » ¸ ¸ » ¹ 1 u 2 ¸ » 2 · ¸ » ¸ ¸ » ¸ ¹ ¹ ¼ 4 · · º ¸ ¸ » ¸ ¸ » ¹ 1 u 2 ¸ » 3 · ¸ » ¸ ¸ » ¸ ¹ ¹ ¼ f12 § 1.
2 · ¨ 1¸ u 2 ¨ 1.0417.
0870 (8.1 ¸ © ¹ 0.0416.70%) f23 § 1.
0426.3 · ¨ 1¸ u 2 2 ¨ 1.
¸ © ¹ 0.0400.92%) f34 § 1.0792 (7.
4 · ¨ 1¸ u 2 ¨ 1.0416.
0704 (7.3 ¸ © ¹ 0. we can set t equal to 1 and vary j from 1 to 3 in the preceding equation: ª§ § S · 2 «¨ ¨1 02 ¸ 2 ¸ «¨ ¨ ¹ © ¨ « 1 «¨ §1 S01 · ¸ ¨ «¨ ¨ 2 ¸ ¹ ¬© © ª 3 «§ § S03 · ¨ ¨1 ¸ «¨ ¨ 2 ¸ ¹ «¨ © 1 «¨ «¨ §1 S01 · ¨ ¸ «© ¨ 2 ¸ © ¹ « ¬ ª 4 «§ § S04 · ¨ ¨1 ¸ «¨ ¨ 2 ¸ ¹ «¨ © 1 «¨ «¨ §1 S01 · ¨ ¸ «© ¨ 2 ¸ © ¹ « ¬ · º ¸ » ¸ » ¸ 1» u 2 ¸ » ¸ » ¹ ¼ 1 º ·2 » ¸ » ¸ ¸ 1» u 2 » ¸ » ¸ » ¹ » ¼ 1 º ·3 » ¸ » ¸ ¸ 1» u 2 » ¸ » ¸ » ¹ » ¼ S12 f12 · § 1.0426.04%) If instead we wanted the expected spot yield curve one period from now under the pure expectations theory.
2 ¨ 1¸ u 2 1 ¸ ¨ 1.0417.
¹ © 0.0870 (8.70%) S13 f13 1 ª º § 1.0416.
0417.3 · 2 » «¨ ¸ 1 u 2 «¨ 1.
1 ¸ » ¹ «© » ¬ ¼ 0.31%) S14 f14 ª 4 «§ 1.0400.0831 (8.
0417. ¨ «¨ 1 «© 1.
0789 (7. Gruber.89%) Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 20 128 . ¬ 1 º ·3 » ¸ 1 u 2 » ¸ ¹ » ¼ 0.
010.240 · ¨ ¸ 27 ¹ © 27 29. Gruber. Elton.700 1000 . the bonds’ current prices would be related as follows: 308/297 PA + 10/297 PB = PC But.048 > $1. 29. Let YA be the fraction of bond A purchased and YB be the fraction of bond B purchased.700 27 1000 . 1 080 . Therefore. we have instead: 308/297 u $982 + 10/297 u $880 = $1. Then we have: t = 1: t = 2: $80 YA + $1.240 2. if the Law of One Price held.080 YA + $0 YB = $1.700 10 297 So buying 308/297 of bond A and 10/297 of bond B gives the same cash flows as buying 1 bond C (or. § 3. bond C would have to sell for $1. buying 308 of bond A and 10 of bond B gives the same cash flows as buying 297 of bond C).Chapter 20: Problem 4 We can use the cash flows bonds A and B to replicate the cash flows of bond C. 27 u 27 29. 28 27 308 297 YB 28 · § ¨120 80 u ¸ 27 ¹ © 1100 . For the Law of One Price to hold. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 20 129 .048. since we are given that PA = $982.100 YB = $120 $1.010 The Law of One Price does not hold.120 Solving the above two equations simultaneously gives: YA 1120 . PB = $880 and PC = $1. equivalently.
Given that the periods shown are annual.Chapter 20: Problem 5 If the Law of One Price holds. the price of each bond must equal the sum of the present values of its future aftertax cash flows. bond B has a capital gain of $1. and bond C has a capital loss of $1.000 $900 = $100. bond A has a capital gain of $1. we need to find the discount factors and ordinary income tax rate that makes the following set of equations hold simultaneously: $80 u 1 T . and that the capital gain or loss tax rate is onehalf of the ordinary income tax rate. Each bond’s capital gain or loss is simply its principal (par) value minus its price. Also. in the presence of taxes. then the same discount rate (which is a spot rate) applies for the cash flows in a particular period for all three bonds.000. where the present values are calculated using the spot rates.000 $1.040 = $40. Given that each bond has a par value of $1.000 $985 = $15. that taxes must be paid on capital gains and can be deducted on capital losses.
u d2 $80 u 1 T .
u d4 $15 u $100 u 1 T .
2 $120 u 1 T . 2 $900 $985 T u d2 $1000 u d 2 . u d 2 100 u T u d4 $1000 u d4 .
u d 2 $120 u 1 T .
d2 = 0.8934 Elton.8568. d2 1 § S02 ¨1 ¨ 2 © 1 § S04 ¨1 ¨ 2 © · ¸ ¸ ¹ 4 T u d4 $1000 u d4 .3303. 2 $1040 . u d4 $40 u where T = the ordinary income tax rate. Gruber. d4 = 0. · ¸ ¸ ¹ 2 = the twosemiannualperiod (oneyear) discount factor. d4 = the foursemiannualperiod (twoyear) discount factor. The solution to the above set of simultaneous equations is: T = 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 20 130 .
semiannual interest payments of $50. Gruber.000 paid at the end of 5 years and a flat yield curve at 10%.05 years.000. we have: § · ¨ ¸ 10 ¨ 50 u t ¸ 1000 u 10 ¨ t ¸ 10 0. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.10 · t 1¨§ ¨1 ¸ ¸ ¨1 ¸ ¨ 2 ¹ 2 ¹ ¹ © ©© 2 u 1000 ¦ D 8.1 4.Elton. a principal of $1. Given P0 = $1. 6th Edition Solutions to Text Problems: Chapter 21 Chapter 21: Problem 1 The duration formula shown in the text for annual payments can easily be modified to reflect semiannual payments as follows: ¦ D § ¨ T ¨ CFt u t ¨ t i· t 1¨§ ¨1 ¸ ¨ ©© 2¹ 2 u P0 · ¸ ¸ ¸ ¸ ¸ ¹ where T is the number of semiannual periods remaining to maturity. 2 Chapter 21: Problem 2 The duration formula for annual payments annual payments is: D ¦ ¨ 1 i .10 · ¸ § 0.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. ¨ t T § CFt u t · ¸ t ¸ 1© ¹ P0 where T is the number of years remaining to maturity. 6th Edition Solutions To Text Problems: Chapter 21 131 . Elton.
we have: D ¦ ¨ 1 0. a principal of $1.000.Given P0 = $1.000 paid at maturity and a flat yield curve at 10%. annual interest payments of $100.10.
¨ t T § 100 u t · 1000 u T ¸ t ¸ T 1© ¹ 1 0.10 .
there are an infinite number of solutions (portfolios) that will satisfy the equation. the duration of a portfolio of those bonds is: DP = 5XA + 10XB + 12(1 XA XB) Setting the portfolio’s duration equal to the target duration of 9. since an investment portfolio’s weights sum to 1.87 4. 6th Edition Solutions To Text Problems: Chapter 21 132 . we have: T 10 8 5 3 D 6. Gruber. XC = 3/14 XA = 10/28. 8. Either XA or XB can be arbitrarily set and then the remaining weights solved for.) 3. XB = 7/28. 5 and 3 years. Three of the infinite number of solutions are: 1. XC = 27/56 XA = 4/14.17 2. Using the above equation. we have: 5XA + 10XB + 12(1 XA XB) = 9 Since there is just one equation with two unknowns. 1000 where T has values of 10.76 5. XB = 7/14.) XA = 22/56.74 Chapter 21: Problem 3 Let XA be the portfolio’s investment weight for bond A. XC = (1 XA XB) be the portfolio’s investment weight for bond C. Given the individual bonds’ durations. XB be the portfolio’s investment weight for bond B. XC = 11/28 Elton. and. XB = 7/56.) 2. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
YC = 15/84 Assuming fractional purchases may be made. we have three equations with three unknowns and therefore one unique solution. there would be many more bonds than the number of liabilities (many more unknowns than the number of equations) and thus there would be an infinite number of solutions. YB = 1/2. and YC be the fraction of C bonds to buy. Let YA be the fraction of A bonds to buy.6) in the text is a form of a singleindex model for bonds: Ri Ri Di Rm R m ei Dm .Chapter 21: Problem 4 Since in this problem there are three bonds with three sets of cash flows to meet the three liabilities.050 YA + $100 YB + $0 YC = $500 $0 YA + $1.000 YC = $250 $1.100 YB + $0 YC = $550 The solution to the above set of simultaneous linear equations is: YA = 9/21.) We want to form a portfolio of these three bonds that replicates the timing and amounts of the liabilities.071. the cost of the bond portfolio is then: YA PA + YB PB + YC PC = 9/21 u $950 + 1/2 u $1. the linear programming procedure shown in the text’s Appendix B would be required to find the leastcost solution. In a more realistic situation. At t = 1: At t = 2: At t = 3: $50 YA + $100 YB + $1. In that case.43 Chapter 21: Problem 5 Equation (21. (Note that these are not investment weights that sum to 1. YB be the fraction of B bonds to buy.000 + 15/84 u $920 = $1.
6th Edition Solutions To Text Problems: Chapter 21 133 . Since the market portfolio is a weighted average of the three bonds. the valueweighted market portfolio is also an equally weighted portfolio. then the first period’s expected return is 10% for each of the three bonds. the duration of the market portfolio is: Dm = 1/3 u 5 + 1/3 u 10 +1/3 u 12 = 9 years Elton. If the yield curve is flat at 10%. the market portfolio also has an expected return of 10%. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. The duration of the market portfolio is a weighted average of the three bonds’ durations. Since the three bonds are assumed to be of equal value. Therefore.
Therefore we have: RA 10% 5 u Rm 10% .
e i 9 10 u Rm 10% .
e i 9 RB 10% RC 10% 12 u Rm 10% .
the covariance between the returns on any pair of bonds i and j is: V ijj Therefore we have: Di Dm u Dj Dm 2 uV m V AB DA Dm DA Dm u DB 2 uV m Dm DC 2 uV m Dm 5 10 2 u uV m 9 9 5 12 2 u uV m 9 9 V AC u V BC DB Dm u DC 2 uV m Dm 10 12 2 u uV m 9 9 Elton. Gruber. the covariance between the returns on any pair of securities i and j is: V ijj 2 E i E jV m Making the same assumptions as those for the Sharpe singleindex model and D recognizing that i in the bond singleindex model (equation (21. under the assumptions of the Sharpe singleindex model.6)) is Dm analogous to Ei in the Sharpe singleindex model. e i 9 We have seen in an earlier chapter that. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 21 134 .
because the stock would be called away from the client. Thus. Gruber. Chapter 22: Problem 2 The profit diagram of buying the two puts appears as follows: Elton. the client would lose the potential profit he would make if the stock were to appreciate in value. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 22 135 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. 6th Edition Solutions to Text Problems: Chapter 22 Chapter 22: Problem 1 Although selling calls today would generate a positive cash flow for the client now.Elton. there is a potential opportunity cost of engaging in that strategy.
the profit would be $17 (a $17 loss). the profit is: P d $50 : Profit = $17 + 2 u ($50 P) = $83 2P (since only the two put options would be exercised) $50 < P: Profit = $17 + P $50 = P $67 (since only the call option would be exercised) Elton.50 or above $67 on the day the options expire. For the combination to have a positive profit. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. letting the stock price on the expiration date = P. the stock must either be below $41. If the options finish at the money. Algebraically.The profit diagram of buying the call appears as follows: Combining the two profit diagrams we have: The thicker line in the above diagram represents the profit from the combination. where the stock price at their expiration equals their strike prices of $50. Gruber. 6th Edition Solutions To Text Problems: Chapter 22 136 .
6th Edition Solutions To Text Problems: Chapter 22 137 .Chapter 22: Problem 3 The profit diagram of writing the two $45 calls appears as follows: The profit diagram of buying the $40 call appears as follows: Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.
letting the stock price on the expiration date = P. If the two $45 call options finish at the money.) If the stock price is greater than $52 on the expiration date. because none of the options would be exercised and therefore the profit is simply the net profit from buying the $40 call option ( $8) and selling the two $45 call options ($10). so the profit declines. reaching zero at a stock price of $52. the profit would be $2. If the $40 call option finishes out of or at the money. the profit will be negative (a loss). Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Algebraically. the profit would be $7. the profit is: P d $40 : Profit = $2 (since no options would be exercised) $40 P $45 : Profit = $2 + P $40 (since only the $40 call option would be exercised) $45 d P : Profit = $2 + P $40 2 u (P $45) = $52 P (since all options would be exercised) Elton.Combining the two profit diagrams we have: The thicker line in the above diagram represents the profit from the combination. at stock prices higher than $45. where the stock price at its expiration is below or equal to that option’s strike price of $40. Gruber. the two $45 call options that were sold will be exercised against the seller and therefore contribute twice the loss. giving a total profit of 0. the profit from the $40 call will be $12 $8 = $4 and the profit from the two $45 calls will be $14 + $10 = $4. where the stock price on their expiration equals their strike price of $45. although exercising the $40 call option continues to contribute a gain. $7 is the maximum profit because. equal to the net profit of $2 from buying and writing the options plus the $5 gain from exercising the $40 call option. 6th Edition Solutions To Text Problems: Chapter 22 138 . (At a stock price of $52.
Given that the option’s exercise price (E) is $60 and the current stock price (S0) is $50. u is the size of each up movement.Chapter 22: Problem 4 From the text. we need to solve for the minimum integer a such that: S0 u u a u d 1a. we know that a is the lowest number of upward moves in the stock price at which the call takes on a positive value at expiration (finishes in the money). d is the size of each down movement and n is the number of periods remaining to the option’s expiration.
9 1a. ! E So we have: $50 u 1.2 a u 0.
972 $60 u 1. P@ So we have: B>5. To value the call option.73@ 0.67 1.9 0. n.926 C $50 u 0.10.972 B>a. Pc@ B>5.1 0. n. P@ r d ud 1.67@ 0. Pc@ Er n B>a. n.73 B>a.10.1.2 u 0. n.1 0.0.67 Pc u uP r 1. we use the binomial formula: C where P S0 B>a.2 0.0. ! $60 and the solution is a = 5.9 1.
10 u 0. 6th Edition Solutions To Text Problems: Chapter 22 139 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.926 $27.18 Elton.
V = 0.08 (8%) Solving for d1 and d2 we have: §S ln¨ 0 ¨ E © · § 1 · ¸ ¨r V 2 ¸ut ¸ 2 ¹ ¹ © V t 1 § 95 · § · 2 ln¨ ¸ ¨ 0. r = 0. E = $105.Chapter 22: Problem 5 The BlackScholes optionpricing formula for valuing a call option is: C We are given: S0 = $95.08 u 0.60. t = 2/3 years (8 months).60 u 3 S0 Nd1 .36 ¸ u 105 ¹ © 2 © ¹ 3 2 0.
E e rt Nd2 .
60 u 3 0.167 0.490 0. d1 0.490 0.341 From the normal distribution we have: Nd1 .073 0.08 u 0.149 d2 §S ln¨ 0 ¨ E © · § 1 · ¸ ¨r V 2 ¸ut ¸ 2 ¹ ¹ © V t 1 § 95 · § · 2 ln¨ ¸ ¨ 0.36 ¸ u 2 © 105 ¹ © ¹ 3 2 0.
Nd2 .
So the value of the call option is: C N0.149.
341. N 0.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.08u 2 3 u 0.67 Elton. 0.367 $16.367 $95 u 0.560 0.560 $105 e 0. Gruber. 6th Edition Solutions To Text Problems: Chapter 22 140 .
6th Edition Solutions to Text Problems: Chapter 23 Chapter 23: Problem 1 The noarbitrage condition for stockindex futures appears in the text as: F P PV D. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.Elton. Gruber.
1 R.
Gruber. The cash flows are as follows: t=0 sell futures borrow $200/(1. Given that F = $200.68 t=1 $200 $192.68 or greater then the arbitrage opportunity is negated. and keeping the remainder as arbitrage profit.68 $4(1.24 $190 0 0 ________ $2.68 ! $190 $4 $186 1.68 per futures contract. receive the future value of the dividends. Therefore. receive the futures price for the index.68 + $4 = $192. we have: $200 $188. R = 6%.06) plus $4 at 6% for six months buy index for delivery against futures contract in six months receive six months of dividends and invest them at 6% total cash flow 0 $188. and PV(D) = $4.06) = $204.24 _______________ 0 So the arbitrage profit is $2. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. and use the proceeds to pay off the loan. Six months from now (t = 1). P = $190.06)=$4.68(1. using some of the borrowed funds to buy the index today (t = 0). If the present value (at t = 0) of transactions costs is $2. 6th Edition Solutions To Text Problems: Chapter 23 141 . borrowing the present value of the futures price and the present value of the dividends at 6% for six months. the arbitrage would involve selling the futures.06 so the futures are overpriced relative to the underlying index. Elton.
Farmers need to be assured that they can sell their crops at harvest time. Chapter 23: Problem3 One equation for interest rate parity that appears in the text is: RD F 1 R F 1 S . so that they can make planting and farm equipment decisions in advance of the harvest.Chapter 23: Problem 2 Yes. So a futures contract makes economic sense from their point of view as well. even if they share the same distributional assumptions as the farmers that spot wheat prices will be lower at the expiration of the futures contract than the futures contract price. regardless of market conditions. since buying futures now eliminates the uncertainty of the cost and availability of wheat later. and knowing the price of wheat in advance helps in making pricing and working capital decisions. since selling futures now eliminates the uncertainty of selling their crops later. futures contracts make sense economically to the farmers. General Mills needs to ensure a steady supply of wheat for their products regardless of market conditions. Even if both farmers and General Mills believe that the spot price at the expiration of the futures contract will be higher than the futures contract price (so that the farmers would get more money selling their crops later on at the spot price than by selling futures).
rate and RF is the rate for Japan. rate gives: 1 D 115 u 1. F = 1/115 and S = 1/120. from the problem. then. if RD is the U. i.S. both F and S are expressed in direct terms. F is the domestic futures price for one unit of foreign currency. RF is the foreign interest rate.04 . and S is the spot exchange rate expressed as domestic currency per unit foreign currency. viewpoint. where RD is the domestic interest rate.S. So solving the above equation for the U.. From a U. so. the quotes given in the problem are in indirect terms.S.e.
04 . 1 R 1 120 120 u 1.
1 115 0.0852 8.52% .
Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 23 142 . Elton.
close out your futures position by delivering your 19year corporate bonds. the value of the futures will fall. Assuming a normal yield curve. In one year. shortterm rates would have to rise more than longterm rates for the spread to narrow. Chapter 23: Problem 6 To lock in today's rates. 6th Edition Solutions To Text Problems: Chapter 23 143 . If instead the entire yield curve shifted up. your 20year corporates have thus been shortened to 1year corporates. and if longterm rates fall and shortterm rates rise. Either way. the effective interest rate on your bond issue is locked in at today's rates by selling futures. longterm rates would have to fall more than shortterm rates for the spread to narrow. At the end of three months. In one year.Chapter 23: Problem 4 Assume you match the durations (interest rate sensitivities) of longterm and shortterm bond futures by holding them long or short in the necessary proportion. then the prices of longterm bonds and longterm bond futures will rise and the prices of shortterm bonds and shortterm bond futures will fall. If interest rates rise. Gruber. sell your corporate bonds and use the proceeds to purchase an offsetting futures contract on 19year government bonds to close out your futures position. A strategy that uses futures that are in fact traded would require selling futures today on 20year government bonds. If interest rates have in fact risen. ignoring basis risk. The additional risk with this strategy is basis risk. use the profits from your futures position to finance the increased interest payments on your bond issue. If the market does not share your belief today. If interest rates have fallen. close out your futures position by buying an offsetting futures contract. when your own bond issue is floated. from your viewpoint today. so the above position would still be profitable. sell $40 million of 10year government bond futures. If the entire yield curve shifted down. so the above position would still be profitable. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Therefore. which is the risk that the prices of government bonds and government bond futures will not move in exactly the same way as corporate bonds of the same maturity. Chapter 23: Problem 5 Assuming that a futures market exists for corporate bonds. you want to be long in longterm bond futures and short in shortterm bond futures. sell futures contracts to deliver $100 million of 19year corporates one year from today. use some of the proceeds from your bond issue to cover your loss from your futures position. you believe that longterm rates will fall relative to shortterm rates. which means a profit for you since you are short the futures. Elton.
Gruber.Elton. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 23 144 .
g. for fund A we have: R A RF 14 3 6 1. is the fund’s average return minus the return on a naïve portfolio. using standard deviation as the measure of risk.. for fund A we have: § · R m RF uV A ¸ R A ¨ RF ¸ ¨ Vm © ¹ 13 3 § · u 6¸ 14 ¨ 3 5 © ¹ 1% See the table in the answers to Problem 5 for the remaining funds’ differential returns based on standard deviation.g. except the fund’s beta is used in the denominator instead of the standard deviation. E.Elton. Gruber. E. 6th Edition Solutions to Text Problems: Chapter 24 Chapter 24: Problem 1 Using standard deviation as the measure for variability.833 See the table in the answers to Problem 5 for the remaining funds’ Treynor ratios. Elton.g.. Chapter 24: Problem 3 A fund’s differential return. the rewardtovariability ratio for a fund is the fund’s excess return (average return over the riskless rate) divided by the standard deviation of return. i.. Chapter 24: Problem 2 The Treynor ratio is similar to the Sharpe ratio.e. Gruber. for fund A we have: R A RF EA 14 3 1. E. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 24 145 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.5 7. the fund’s Sharpe ratio. consisting of the market portfolio and the riskless asset. with the same standard deviation of return as the fund’s..833 VA See the table in the answers to Problem 5 for the remaining funds’ Sharpe ratios.
for fund A we have: R A RF R m RF u E A . with the same beta as the fund’s. consisting of the market portfolio and the riskless asset.Chapter 24: Problem 4 A fund’s differential return.” E. is the fund’s average return minus the return on a naïve portfolio. using beta as the measure of risk.g.. This measure is often called “Jensen’s alpha.
.
14 3 13 3 .
5. u 1.
. Chapter 24: Problem 5 This differential return measure is the same as the one used in Problem 4. except that the riskless rate is replaced with the average return on a zerobeta asset. E. 4% See the table in the answers to Problem 5 for the remaining funds’ Jensen alphas. for fund A we have: RA RZ Rm RZ u E A .g.
.
14 4 13 4 .
5. u 1.
6th Edition Solutions To Text Problems: Chapter 24 146 . 3.0% Elton.063 1.500 Differential Return Based On Standard Deviation 1% 1% 3% 5% 3% Differential Return Based On Beta and RF 4% 4% 3% 2% 3% Differential Return Based On Beta and R Z 3. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.250 1.5% 3.000 13. Gruber.5% 3.700 Treynor Ratio 7.833 2.5% 2.000 8.0% 1.333 18.5% The answers to Problems 1 through 5 for all five funds are as follows: Fund A B C D E Sharpe Ratio 1.625 1.000 14.
33%. Solving for the average return that would make Fund B’s Sharpe ratio equal to Fund A’s we have: R B Rf RB 3 4 1.Chapter 24: Problem 6 Looking at the table in the answers to Problem 5. for the ranking to be reversed.33% So. Fund B’s average return would have to be lower than 10. Elton.833 VB or RB 10. we see that Fund B is ranked higher than Fund A by their Sharpe ratios. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. 6th Edition Solutions To Text Problems: Chapter 24 147 . Gruber.
Gruber. 6th Edition Solutions To Text Problems: Chapter 24 148 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.Elton.
05 0.01 0. The points on a Predictive Realization Diagram would have the following coordinates (where Pi = predicted change in earnings and Ri = realized change in earnings): Industry/Firm A1 A2 A3 B4 B5 B6 B7 C8 C9 C10 Pi 0.02 Ri 0. It is very clear from the diagram that analysts in this brokerage firm systematically overestimate earnings. for the computation of mean square forecast error (MSFE). there is a slight (based on one observation) tendency for analysts to overestimate the size of a decrease in earnings when a decrease takes place.25 0.03 0.06 0. We will do the MSFE analysis using levels and the following formula: MSFE 1 N ¦ F A .04 0.03 0.05 0.070 0.05 0. The second marked tendency is fro the degree of overestimation to grow as positive increases in earnings become larger.75 0. Their forecasts have a strong upward bias.00 0. 6th Edition Solutions to Text Problems: Chapter 25 Chapter 25: Problem 1 A. the results are the same whether we use predicted levels or predicted changes in earnings.65 0.04 0.02 While there are only ten points on the Prediction Realization Diagram.01 0. certain tendencies can be detected. B. Similarly.01 .20 0.40 0.Elton. Recall from the text that. Gruber. The analysts misestimated the direction of a change in earnings in only two out of the ten cases. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.
6th Edition Solutions To Text Problems: Chapter 25 149 . Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber. i i i 1 N 2 where Fi is the forecasted level of earnings for firm i per share Ai is the actual earnings per share for firm i. Elton.
06 $2.12 $2.10 $1.16 Ai $1.10 $2.25 $2.06 $2.70 $0.80 $1.25 $1.35 $3.54 $1.13 $3.25 $2.40 $0.12 $2.20 Sum Fi Ai .Industry/Firm A1 A2 A3 B4 B5 B6 B7 C8 C9 C10 Fi $1.05 $1.52 $1.37 $4.
0004 1.0000 0.0000 0.2 0.0004 0.2979 10 0.0016 1.0004 0.0900 0.1298 C.2979 Therefore: MSFE 1. we know that the MSFE can be decomposed by level of aggregation as follows: MSFE P R.0025 0. From the text.0001 0.2025 0.
2 1 N ¦ >P N i 1 a P Ra R .
.
@ 2 1 N ¦ >P P .
R N i a i 1 i Ra .
and the third term measures the error due to individual analysts misestimating the differential earnings for particular companies within an industry from the average for that industry.@ 2 where the first term measures the forecast error due to all analysts misestimating the average earnings in the economy. the second term measures the error due to individual analysts misestimating the differential earnings for particular industries from the average for the economy. So we have: Error due forecasting sector of economy: P R.
048. 2 0.223 0.
Brown and Goetzmann Modern Portfolio Theory and Investment Analysis. Gruber.0306 Elton.2 0. 6th Edition Solutions To Text Problems: Chapter 25 150 .
2833 0.Error due forecasting each industry: § 3 u >0.223.
048.0733 0. 0.
1825 0.223.@2 · ¨ ¸ 1 ¨ 2¸ u 4 u >0.
048.0725 0. 0.
@ ¸ 10 ¨ ¨ 3 u >0.223.2167 0.
1367 0.048. 0.
@2 ¸ © ¹ 0.0143 1 N ¦ >P N i 1 a P Ra R .
.
0989 0.0271.0169 0.@ 2 1 u 0.
10 Error due forecasting each firm: 1 N ¦ >P P .
R N i a i 1 i Ra .
57% Percent of forecast error due to forecasting each industry = 11.02% Percent of forecast error due to forecasting each firm = 65.@ 2 0. 1. which is the total MSFE we calculated earlier.41% D. simply divide each component by 0.1298. To express each component as a percentage of the total MSFE.0849 Notice that the sum of the three components equals 0.1298 and multiply by 100: Percent of forecast error due to forecasting sector of economy = 23. MSFE for each analyst: MSFE(A) 1 u 3 ¦ P R .
Gruber. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0508 MSFE(C) = 0. 6th Edition Solutions To Text Problems: Chapter 25 151 . i i i 1 3 2 1 u 1.0307 Elton.3343 MSFE(B) = 0.0029 3 0.
Industry Error = PA RA = = 1 3 3 .2. MSFE decomposition for each analyst: For analyst A.
1272 RA Company Error ¦ >P P . 2 = 0.
R i A i 1 >Pi 0.2833.
0733. Ri 0.
.
@2 3 i1 = 0.2071 ¦ i 1 3 .
95% 0.1272 u 100 = 38.3343 % Company Error = For analyst B.@ 2 % Industry Error = 0.2071 u 100 = 61.1825 0.0725.3343 0. Industry Error = 0.05% 0.
1825. = 0.0121 2 Company Error = 1 4 >Pi 0.
Ri 0.0725.
2167 0. Industry Error = 0.@2 4 i1 = 0.8% = 76.2% For analyst C.0387 ¦ % Industry Error % Company Error = 23.1367.
0064 2 Company Error 1 3 >Pi 0. = 0.2167.
Ri 0.1367.
8% = 79. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.0243 = ¦ % Industry Error % Company Error = 20. Gruber.2% 152 Elton. 6th Edition Solutions To Text Problems: Chapter 25 .@2 3 i1 = 0.
not N 1. The calculations in this part use N. Error Due To Bias = P R . in the denominator for variances.E.
223 0. 2 = 0.048.
= 0.0306 2 2 2 Error Due To Variance = V P V R .
3144 0. = 0.1569.
= 0.0248 Error Due To Covariance = 2 u 1 U PR .
2461.V PV R = 2 u 1 0.
3144 u 0.1298 0. 6th Edition Solutions To Text Problems: Chapter 25 153 .32% 0.1298 % Error Due To Covariance = Elton. Gruber.1569 = 0.0744 u 100 = 57. u 0.0744 % Error Due To Bias = 0.1298 % Error Due To Variance = 0.0248 u 100 = 19. Brown and Goetzmann Modern Portfolio Theory and Investment Analysis.57% 0.0306 u 100 = 23.11% 0.
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