Chapter 05 - Risk and Return: Past and Prologue

CHAPTER 05
RISK AND RETURN: PAST AND PROLOGUE
5. E(r) = [0.4 38%] + [0.3 21%] + [0.3 (19%)] = 15.8%
2 = [0.4 (38 15.8)2] + [0.3 (21 15.8)2] + [0.3 (19 15.8)2]
= 23.84%
The mean is unchanged, but the standard deviation has increased.
6.
7.
a. Time-weighted average returns are based on year-by-year rates of return.
Year
2010-2011
2011-2012
2012-2013

Return = [(capital gains + dividend)/price]

(129 120 + 2)/120 = 9.17%
(115 129 + 2)/129 = 9.30%
(120 115 + 2)/115 = 6.09%

Arithmetic mean: 1.98%

Geometric mean: 1.65%
b.
Time
0
1

Cashflow
-720
-246

131

854

Explanation
Purchase of six shares at $120 per share
Purchase of two shares at $129,
plus dividend income on six shares held
Dividends on eight shares,
plus sale of one share at $115
Dividends on seven shares,
plus sale of seven shares at $120 per share

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Chapter 05 - Risk and Return: Past and Prologue

Date:

1/1/10
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|
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|
720

131
|
|
1/1/12

1/1/11
|
|
|
|
246

854
|
|
|
|
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1/1/13

Dollar-weighted return = Internal rate of return = 0.7483%

8.
a. E(rP) rf = AP2 = 4 (0.20) = 0.16= 16%
b. 0.09 = AP2 = A (0.20) A = 0.09/(0.04) = 2.25
c. Increased risk tolerance means decreased risk aversion (A), which results in a
decline in risk premiums.
12.
a. E(rP) = (0.2 4%) + (0.8 12%) = 10.4% per year
P = 0.8 28% = 22.4% per year
b.
Security
T-Bills
Stock A
Stock B
Stock C

0.8 20% =
0.8 30% =
0.8 50% =

Investment
Proportions
20.0%
16.0%
24.0%
40.0%

c. Your Reward-to-variability ratio = S =

Client's Reward-to-variability ratio =

5-2

12 4
= 0.2857
28

10.4 4
= 0.2857
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Chapter 05 - Risk and Return: Past and Prologue

d.

13.
a. Mean of portfolio = (1 y)rf + y rP = rf + (rP rf )y = 4 + 8y
If the expected rate of return for the portfolio is 15%, then, solving for y:
11 = 4 + 8y y =

11 4
= 0.875
8

Therefore, in order to achieve an expected rate of return of 11%, the client

must invest 87.5% of total funds in the risky portfolio and 12.5% in T-bills.
b.
Security
T-Bills
Stock A
Stock B
Stock C

0.875 20% =
0.875 30% =
0.875 50% =

Investment
Proportions
12.5%
17.5%
26.25%
43.75%

c. P = 0.875 28% = 24.5% per year

14.
a. Portfolio standard deviation = P = y 28%
If the client wants a standard deviation of 20%, then:
y = (20%/28%) = 0.7143 = 71.43% in the risky portfolio.
b. Expected rate of return = 4 + 8y = 4 + (0.7143 8) = 9.71%
15.
a. Slope of the CML =

13 4
= 0.36
25

See the diagram on the next page.

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Chapter 05 - Risk and Return: Past and Prologue

b. My fund allows an investor to achieve a lower expected rate of return for any
given standard deviation than would a passive strategy, i.e., a lower expected
return for any given level of risk.

16.
a. With70%ofhismoneyinmyfund'sportfolio,theclienthasanexpectedrateof
returnof12%peryearandastandarddeviationof28%peryear.Ifheshifts
thatmoneytothepassiveportfolio(whichhasanexpectedrateofreturnof13%
andstandarddeviationof25%),hisoverallexpectedreturnandstandard
deviationwouldbecome:
E(rC) = rf + 0.7(rM rf)
In this case, rf = 4% and rM = 13%. Therefore:
E(rC) = 4 + (0.7 (13% - 4%)) = 10.3%
The standard deviation of the complete portfolio using the passive portfolio
would be:
C = 0.7 M = 0.7 25% = 17.5%
Therefore, the shift entails a decline in the mean from 12% to 10.3% and a decline
in the standard deviation from 25% to 17.5%. Since both mean return and
standard deviation fall, it is not yet clear whether the move is beneficial. The
disadvantage of the shift is apparent from the fact that, if my client is willing to
accept an expected return on his total portfolio of 10.3%, he can achieve that
return with a lower standard deviation using my fund portfolio rather than the
passive portfolio.
To achieve a target mean of 10.3%, we first write the mean of the complete
portfolio as a function of the proportions invested in my fund portfolio, y:
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Chapter 05 - Risk and Return: Past and Prologue

E(rC) = 7 + y(13 4) = 7 + 9y
Because our target is: E(rC) = 10.3%, the proportion that must be invested in my
fund is determined as follows:
10.3 = 7 + 9y y =

10.3 7
= 0.3667
9

The standard deviation of the portfolio would be:

C = y 28% = 0.3667 28% = 10.27%
Thus, by using my portfolio, the same 10.3% expected rate of return can be
achieved with a standard deviation of only 10.27% as opposed to the standard
deviation of 17.5% using the passive portfolio.
Alternatively, if your client stick to Your Portfolio with 70% of his investment,
his return will be: E(rC) = rf + 0.7(ryour portfolio rf)
In this case, rf = 4% and ryour portfolio = 12%. Therefore:
E(rC) = 4 + (0.7 (12% - 4%)) = 9.6%
The standard deviation of the complete portfolio would be:
C = 0.7 M = 0.7 28% = 19.6%
Comparing the Sharpe ratio of investing 70% in Your portfolio with investing
70% in the passive fund:
Sharpe ratio of investing 70% in Your Portfolio: (9.6% - 4%)/19.6% = 0.28
Sharpe ratio of investing 70% in Passive Fund: (10.3% - 4%)/17.5% = 0.36
b. The fee would reduce the reward-to-variability ratio, i.e., the slope of the CAL.
Clients will be indifferent between my fund and the passive portfolio if the
slope of the after-fee CAL and the CML are equal. Let f denote the fee:
Slope of CAL with fee =

12 4 f
8 f
=
28
28

Slope of CML (which requires no fee) =

13 4
= 0.36
25

Setting these slopes equal and solving for f:

8 f
= 0.36
28

8 f = 28 0.36 = 10.08
f = 8 10.08 = -2.08% per year

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Chapter 05 - Risk and Return: Past and Prologue

Important note: Question 16 has problem. It requires the comparison between portfolio
return and market return. Portfolio return in the old book is higher than market return.
When the value is changed in the new book, portfolio return becomes less than the
market return.. It makes Question 16 becoming strange.

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