Tutorial II Solution

Question 1
a. Variance measures the total risk of a security and is a measure of stand-alone risk. Total
risk has both unique risk and market risk. In a well-diversified portfolio, unique risks tend
to cancel each other out and only the market risk is remaining. Beta is a measure of
market risk and is useful in the context of a well-diversified portfolio. Beta measures the
sensitivity of the security returns to changes in market returns. Market portfolio has a
beta of one and is considered the average risk.
b. If we hold long positions in both stocks: the correlation coefficient that gives the
maximum reduction in risk for a two-stock portfolio is -1. If one stock is sold short and
another stock is a long position in the portfolio then a correlation of +1 is actually best to
minimize portfolio risk.
c. Mean A = 8%, Mean M=16%, Cov(Ra, Rm)=0.0138, Var(Rm)=0.0084,
Beta=0.0138/0.0084=1.643.
d. Cov(Rb,Rm)= (0.8)(0.20)(0.35) = 0.056, Beta = 0.056/0.04 = 1.4.
Question 2
a. we first need to find the number of share bought from each stock:
nA=200,000*0.5/25=4,000
nB=200,000*0.25/80=625
nC=200,000*0.25/2=25,000
The new value of the portfolio is
P=30nA+60nB+3nC=232,500

c. The portfolio weight are the fraction of value invested in each stock
wA=30nA/232,500=51.61%
wB=60nB/232,500=16.13%
wC=3nC/232,500=32.26%
Question 3