Tutorial (7)

Capital Market line

 True or False
The CML connects the RFR and the Market portfolio or
any other portfolios that possess risky assets by a linear
relationship.

True
Complete the following
A
B A: Borrowing
B: Lending
M: Market Portfolio

A:……………..
B:……………..
The point M tangent the Efficient Frontier with the CML:…………
 True or False
All the portfolios on the CML have a positive
correlation with the market portfolios, and so the
assumption of the elimination of systematic risk is also
applied on it.
False
All the portfolios on the CML have a positive
correlation with the market portfolios, and so the
assumption of the elimination of unsystematic risk is
 Complete

The investor can …(a)…..and choose a point higher than

the Market portfolio, or the investor can …(b)…. part, of
his money and choose another point lower than the
market portfolio

a)borrow

b)lend
True or False
Measuring the total risk by standard deviation, while
not considering unsystematic risk, is considered an
advantage in the CML

False
measuring the total risk by standard deviation, while
not considering unsystematic risk, is considered a
drawback in the CML
Complete

?
Mr. Ahmed decided to set aside a small part of his wealth for
investment in a portfolio that has a greater risk than his previous
investments because he anticipates that the overall market will
generate attractive returns in the future. He assumes that he can
borrow money at 7% and achieve the same return on the S&P 500
as before :
an expected return of 20% with a standard deviation of 28%.
Calculate his expected risk and return if he borrows 25%, 50 %,
75%, and 100% of his initial investment amount.
 Solution:
The leveraged portfolio’s standard deviation and return can be calculated with the following equations:

The proportion invested in T-bills becomes negative instead of positive

because Mr. Ahmed is borrowing money . If 25% of the initial investment is
borrowed

= - 0.25 , and ( 1 – ) = 1- ( -0.25) = 1.25 , etc.

 Return with =- 0.25
E() = (-0.25 7%) + (1.25 20%) = 0.2325= 23.25%
Standard Deviation = 1.25 28% = 0.35=35%

Return with =- 0.50

E() = (-0.50 7%) + (1.50 20%) =0.265 = 26.5%
Standard Deviation = 1.50 28% =0.42=42%

Return with =- 0.75

E() = (-0.75 7%) + (1.75 20%) =0.2975 = 29.75%
Standard Deviation = 1.75 28% =0.49=49%

Return with =- 1.00

E() = (-1.00 7%) + (2.00 20%) =0.33=33%
Standard Deviation = 2.00 28% =0.56=56%
Calculate The Beta for the following knowing that the variance of
the Market is equal to 0.0784
1-A security’s standard deviation is 55% and the correlation with
the market is -0.8.
2- An Asset has zero correlation with the Market and has a
Standard deviation higher than the standard deviation of the
market.
3-A short-term debt instruments issued by governments.
4-An initial public offering or new issue of stock with a standard
deviation of 45% and a correlation with the market of 0.6.
Solution:

1-Beta of the security is -0.8 x0.55 ÷0.28 = -1.57

2-because the correlation of the asset with the market is zero. its
beta is zero.
3-A short-term debt instruments issued by governments are
called T-bills. They have zero risk. Therefore, its beta is zero.
4-Beta of the initial public offering is 0.6 x0.45 ÷0.28 =0.96
• You invest 10 percent of your money in a risk-free asset, 20 percent in the market
portfolio, and 70 percent in a US stock that has a beta of 1.3. Given that the risk-
free rate is 6 % and the market return is 14 %, what are the portfolio’s beta and
expected return?

Answer
The beta of the risk-free asset = zero, the Beta of the Market = 1, and the beta of US
stock is 1.3. The portfolio beta is
• Bp= W1B1 +W2B2 + W3B3
=(0.1 * 0) + (0.2 * 1 ) + (0.7* 1.3) = 1.11
• E(Ri) = Rf + B (E(Rm)-Rf)
=0.06 + 1.11 * (0.14 – 0.06 ) = 0.1488 =14.88%