Problem 1:

State of the Probability Eggbert’s Egg Co. Dino’s Dingo Co.

world
1 Good 60% 40% 30%
2 Ugly 40% 20% 30%

a)       Compute the expected return for each security.

Eggbert’s Egg Co. E(e) = 32.00%

Dino’s Dingo Co. E(d) = 30.00%

b)       Compute the variance for each security.

Eggbert’s Egg Co. Var(e)= 0.0096 Std Dev(e) = 9.80%

Dino’s Dingo Co. Var(d)= 0.0000 Std Dev(d) = 0

coefficient.

COV(E,D) = 0.00

CORR(E,D) = 0.00

d)       Compute the standard deviation of a portfolio with weights of 20% on Eggbert and 80% on Dino.

We = 20%
Wd = 80%

STD pf = 1.9596%

e)        Plot  the  positions  of  the  two  securities  on  a  mean-variance  diagram.  Pick  several  other 
portfolio  weights  and  plot  these  portfolios  on  the  mean-variance  diagram.  Connect  the  dots, 
drawing a smooth curve.

We = Wd = STDpf (Wi,Wj) Variance Expected return

0.00% 100.00% 0.00% 0 30.00%
10.00% 90.00% 0.98% 0.000096 30.20%
20.00% 80.00% 1.96% 0.000384 30.40%
30.00% 70.00% 2.94% 0.000864 30.60%
40.00% 60.00% 3.92% 0.001536 30.80%
50.00% 50.00% 4.90% 0.0024 31.00%
60.00% 40.00% 5.88% 0.003456 31.20%
70.00% 30.00% 6.86% 0.004704 31.40%
80.00% 20.00% 7.84% 0.006144 31.60%
90.00% 10.00% 8.82% 0.007776 31.80%
100.00% 0.00% 9.80% 0.0096 32.00%
110.00% -10.00% 10.78% 0.011616 32.20%
120.00% -20.00% 11.76% 0.013824 32.40%
 130.00% -30.00% 12.74% 0.016224 32.60%
140.00% -40.00% 13.72% 0.018816 32.80%
150.00% -50.00% 14.70% 0.0216 33.00%
160.00% -60.00% 15.68% 0.024576 33.20%
170.00% -70.00% 16.66% 0.027744 33.40%
180.00% -80.00% 17.64% 0.031104 33.60%
190.00% -90.00% 18.62% 0.034656 33.80%
200.00% -100.00% 19.60% 0.0384 34.00%

35.00%
Expected Return

34.00%

33.00%

Mean
Variance
32.00% Eggbert
Dingo

31.00%

30.00%

29.00%
0 0.005 0.01 0.015 0.02 0.025 0.03 0.035 0.04 0.045
Variance

In the homework, I had asked you to plot the Mean-Variance diagram.

What I really meant by the mean-variance diagram is the expected return 
plotted against the standard deviation.

35.00%
Expected Return

34.00%

33.00%

Mean
Variance
32.00% Eggbert
Dingo

31.00%

30.00%

29.00%
 E
33.00%

Mean
Variance
32.00% Eggbert
Dingo

31.00%

30.00%

29.00%
0.00% 5.00% 10.00% 15.00% 20.00% 25.00%
Standard deviation

Notice how taking the square root of the Variance straightens out the 
curve. 

Also understand the reason why the Mean-Variance diagram is a straight 
line:

f)       Explain how to construct a portfolio whose expected return is higher than the asset with 
the largest expected return. What weight would we need to place on Eggbert?

The asset with the largest expected return is Eggbert, with a expected return of 
32%. In this world with only two risky assets, we can see that being invested 
solely in EggBert will yield the highest return. One could sell Dino short 
(negative weight) and invest the proceeds in Eggbert (weight greater than 1). We 
g)       Find the risk aversion coefficient A corresponding to a quadratic investor, such that he 
places an optimal portfolio weight of 20% on Eggbert.

The solution would be to solve this equation:

2
¿ E (r D) - E (r E) + A (σ E - σ DE )
wD =
A ( σ 2D + σ 2E - 2 σ DE )
Using Wd as Weight on Dino stock, we want (1-We) = 80% = Wd

And find that A = 10.41667 Note that in this case the formula we saw for the case with 2 risky securities, reduces
we saw for 1 risky and 1 risk-free asset, because Dingo is risk free.

Problem 2:
 State of the Probability Eggbert’s Egg Co. Dino’s Dingo Co.
world
1 Good 60% 40% 40%
2 Bad 20% 20% 20%
3 Ugly 20% 10% 30%

a)       Compute the expected return for each security.

Eggbert’s Egg Co. E(e) = 30.00%

Dino’s Dingo Co. E(d) = 34.00%

b)       Compute the variance for each security.

Eggbert’s Egg Co. Var(e)= 0.0160 Std Dev(e) = 12.65%

Dino’s Dingo Co. Var(d)= 0.0064 Std Dev(d) = 8.00%

coefficient.

COV(E,D) = 0.008

CORR(E,D) = 0.7906

d)       Compute the standard deviation of a portfolio with weights of 20% on Eggbert and 80% on Dino.

We = 20%
Wd = 80%

STD pf = 8.54%
e)        Plot  the  positions  of  the  two  securities  on  a  mean-variance  diagram.  Pick  several  other 
portfolio  weights  and  plot  these  portfolios  on  the  mean-variance  diagram.  Connect  the  dots, 
drawing a smooth curve.

We = Wd = STDpf (Wi,Wj) Variance Expected return

-300.00% 400.00% 23.32% 0.054400 46.00%
-290.00% 390.00% 22.57% 0.050944 45.60%
-280.00% 380.00% 21.82% 0.047616 45.20%
-270.00% 370.00% 21.08% 0.044416 44.80%
-260.00% 360.00% 20.33% 0.041344 44.40%
-250.00% 350.00% 19.60% 0.038400 44.00%
-240.00% 340.00% 18.86% 0.035584 43.60%
-230.00% 330.00% 18.14% 0.032896 43.20%
-220.00% 320.00% 17.42% 0.030336 42.80%
-210.00% 310.00% 16.70% 0.027904 42.40%
-200.00% 300.00% 16.00% 0.025600 42.00%
-190.00% 290.00% 15.30% 0.023424 41.60%
-180.00% 280.00% 14.62% 0.021376 41.20%
-170.00% 270.00% 13.95% 0.019456 40.80%
 -160.00% 260.00% 13.29% 0.017664 40.40%
-150.00% 250.00% 12.65% 0.016000 40.00%
-140.00% 240.00% 12.03% 0.014464 39.60%
-130.00% 230.00% 11.43% 0.013056 39.20%
-120.00% 220.00% 10.85% 0.011776 38.80%
-110.00% 210.00% 10.31% 0.010624 38.40%
-100.00% 200.00% 9.80% 0.009600 38.00%
-90.00% 190.00% 9.33% 0.008704 37.60%
-80.00% 180.00% 8.91% 0.007936 37.20%
-70.00% 170.00% 8.54% 0.007296 36.80%
-60.00% 160.00% 8.24% 0.006784 36.40%
-50.00% 150.00% 8.00% 0.006400 36.00%
-43.75% 143.75% 7.89% 0.006225 35.75%
-40.00% 140.00% 7.84% 0.006144 35.60%
-30.00% 130.00% 7.76% 0.006016 35.20%
-25.00% 125.00% 7.75% 0.006000 35.00%
-20.00% 120.00% 7.76% 0.006016 34.80%
-10.00% 110.00% 7.84% 0.006144 34.40%
0.00% 100.00% 8.00% 0.006400 34.00%
10.00% 90.00% 8.24% 0.006784 33.60%
20.00% 80.00% 8.54% 0.007296 33.20%
30.00% 70.00% 8.91% 0.007936 32.80%
40.00% 60.00% 9.33% 0.008704 32.40%
50.00% 50.00% 9.80% 0.009600 32.00%
60.00% 40.00% 10.31% 0.010624 31.60%
70.00% 30.00% 10.85% 0.011776 31.20%
80.00% 20.00% 11.43% 0.013056 30.80%
90.00% 10.00% 12.03% 0.014464 30.40%
100.00% 0.00% 12.65% 0.016000 30.00%
110.00% -10.00% 13.29% 0.017664 29.60%
120.00% -20.00% 13.95% 0.019456 29.20%
130.00% -30.00% 14.62% 0.021376 28.80%
140.00% -40.00% 15.30% 0.023424 28.40%
150.00% -50.00% 16.00% 0.025600 28.00%

45.00%
Expected Return

40.00%

Mean
Variance
35.00% Eggbert
Dingo

30.00%

25.00%

0 0% 0 0% 0 0% 00
% 0% 00% 00% 00% 00% 00% 00%
5. 7. 9. . .0 . . . . . .
11 13 15 17 19 21 23 25
Standard deviation
 30.00%

25.00%

0 0% 0 0% 0 0% 00
% 0% 00% 00% 00% 00% 00% 00%
5. 7. 9. . .0 . . . . . .
11 13 15 17 19 21 23 25
Standard deviation

f)       Explain how to construct a portfolio whose expected return is higher than the asset with 
the largest expected return. What weight would we need to place on Eggbert?

Int this new world, the asset with the largest expected return is Dingo, with an 
expected return of 34%.
In this world with two risky assets, we can see that being invested solely in 
Dingo will yield the highest return with an even smaller variance.
g)       Find the risk aversion coefficient A corresponding to a quadratic investor, such that he 
places an optimal portfolio weight of 20% on Eggbert.

The solution would be to solve this equation:

* E( r D ) - E( r E ) + A(  2E -  DE )
w =
D
A (  2D +  2E - 2  DE )

Using Wd as Weight on Dino's stock, we want (1-We) = 80% = Wd

And find that A = -13.89 which obviously makes no sense, RIGHT!!!!!!!

40.00%
Expected Return

38.00%

Mean Variance
36.00%
Non Existent Investor

Portfolio that optimal investor

34.00% would choose

32.00%

30.00%
7.50% 8.00% 8.50% 9.00% 9.50% 10.00%
Standard deviation
 Non Existent Investor

Portfolio that optimal investor

34.00% would choose

32.00%

30.00%
7.50% 8.00% 8.50% 9.00% 9.50% 10.00%
Standard deviation

h)   Find the expected return and standard deviation of the minimum variance portfolio.

This is the formula for the minimum variance portfolio weights:

σ 2E - σ DE
w min
D =
σ 2D + σ 2E - 2 σ DE
Wd min = 1.25
We min = -0.25
Expected Return

40.00%

38.00%

36.00%
Mean Variance
Minimum variance
portfolio
34.00%

32.00%

30.00%
7.50% 8.00% 8.50% 9.00% 9.50% 10.00%
Standard deviation

Suppose there is a risk free asset, and one can borrow at the risk free rate of 15%, but no lending is allowed.

i)    Find the optimal weights on Eggbert and Dino that any borrower would choose.

w *
=
 E r   r  -  E r   r 
D f
2
E E f DE
D
 E r   r  +  E r   r     E r   r  E r   r  
D f
2
E E f
2
D D f E f DE

 w*E  1  w*D
 w *
=
 E r   r  -  E r   r 
D f
2
E E f DE
D
 E r   r  +  E r   r     E r   r  E r   r  
D f
2
E E f
2
D D f E f DE

 w*E  1  w*D
Risk Free Rate = 15%

Wd optimal = 143.75%
We optimal = -43.75%

j)    Compute the expected return and variance of this portfolio.

E(Pf) = 35.75%
Var (Pf) = 0.006225
Std Dev (Pf) = 7.89%
Expected Return

40.00%

38.00%

36.00% Mean Variance

Optimal Portfolio that we would
all choose
34.00%

32.00%

30.00%
7.50% 8.00% 8.50% 9.00% 9.50% 10.00%
Standard deviation

k) Find the maximum coefficient of risk aversion A corresponding to a quadratic investor, such that he    
would still be a borrower (That is find the A such that he would be indifferent between
borrowing and not borrowing).

Here we want the investor to be a borrower. For this to happen, we need set Wp >= 1 s
that the investor will be on the right side of the optimal portfolio (on the right side of 

E( r A ) - r f
w=
*
>= 1
A 2A
 A max = 33.33

l)Find the coefficient of risk aversion A, of a borrower, who places a weight of 1.5 on the portfolio you
computed in part i.

E( r A ) - r f
*
w=
A 2A
A 150% = 22.22
 - σ DE ) E( r D ) - r f
=
σ DE ) A σ 2D
h 2 risky securities, reduces to exactly the formula