Econ 1710 Investments I

Fall 2015 - KUO

Homework #5: Chapter 7
Homework is due on Wednesday, October 14, 2015, handed in at either the START or the END
of class. Since I am giving everyone until Wed due to Long Weekend, NO LATE HOMEWORK is
accepted. I would also encourage you to make a copy of this HW to use for section as we will not
be able to return them before sections are held. As stated on the syllabus, homework is graded
on completion and good faith effort, determined at my discretion.
This homework is tedious with many calculations.
Q1) A long-lost wealthy elderly relative has unexpectedly decided to gift you a substantial sum
of money for graduating from Brown. You are now considering how to best invest this sum and
have three mutual funds in consideration, as follows:
A money market fund that yields a rate of 3%;
A broad-based equity fund (E), with expected return of 11% and =18%; and
A bond fund (D) comprised of both government and corporate bonds, with expected
return of 7% and standard deviation 12%.
Also, the correlation between the bond and equity funds is 0.60.
(1a) What is the optimal risky portfolio (i.e. what are the optimal proportions of each
risky asset), its expected return and its standard deviation?
( , )
Hint: Remember that =

(1b) What is the reward-to-volatility ratio of the best feasible CAL? Draw a graph that
shows both the portfolio opportunity set (just draw the generic graph and label key
points dont spend time actually graphing all points) and the best feasible CAL, labelling
the optimal risky portfolio (P), its values (E(rP) and P) and the slope and intercept of the
CAL.
(1c) Suppose you require that your (complete) portfolio to yield an expected return of
7.5% and that it be efficient (that is, lie on the best feasible CAL).
(i)
What is the standard deviation of your portfolio?
(ii)
What is the proportion invested in the MMF and in each of the two risky
funds?
(1d) Suppose instead that you were to invest only the two risky funds and still require an
expected return of 7.5%. What would your investment proportions in your portfolio
become? What is the standard deviation of this portfolio? Compare it to the standard
deviation from the portfolio in Question (1c) what can you conclude?
Q2) Consider the following probability distribution for stocks A and B. (Do these questions using a
calculator as they are similar to exam questions so you might as well simulate exam conditions.)

Scenario
1
2
3

Probability
0.30
0.50
0.20

Return on Stock A
10%
14%
11%

Return on Stock B
9%
8%
6%

(2a) What are the expected returns and standard deviations for stocks A and B?
(2b) What is the correlation coefficient between the two stocks?
(2c) Suppose the risk-free rate is 3%. What is the optimal risky portfolio, its expected
return and its standard deviation?
(2d) Suppose instead that stocks A and B had the expected return and standard
deviations as you calculated in part (a), but were perfectly negatively correlated. Again,
assume the risk-free rate is 3%. Describe the global minimum variance portfolio in this
case (that is, the optimal proportions, the expected return and standard deviation).
Q3) Suppose that stocks offer an expected return of 18% with a standard deviation of 22%,
while gold offers an expected return of 10% with a standard deviation of 30%. Given that gold
offers a lower return at higher risk compared to stocks, would anyone hold gold? Why or why
not?
END.