ICMA Centre

Securities, Futures & Options

Solution Set 2
1) Buying insurance on her house and car shows that Ms G is willing to pay a positive risk
premium to avoid uncertainty about her future wealth (which includes all Ms G’s assets).
This is consistent with risk aversion. Life insurance poses more difficult questions, since
future wealth may be less relevant when an individual is dead. Perhaps she is
concerned about uncertainty in the wealth of her partner or children, and takes this into
account when choosing what financial assets to hold. On this broader view of the
wealth or consumption, she is trying to optimise, buying life insurance is also consistent
with risk aversion.

Betting on horse racing doesn’t sound very risk-averse. Perhaps, she believes that she
has superior forecasting ability and can beat the odds. These depend, after all, on what
other punters think, and Ms G may think they are less clever that she is. More probably,
though, she has no special skill, and horse race betting is a gamble which offers no
positive risk premium. Assuming that there is no clever way to play this lottery, buying
lottery tickets is definitely gambling. How can this be consistent with the risk aversion
that Ms G seems to exhibit in other ways?

One possible explanation is that Ms G derives some pleasure from gambling on the
lottery or at the track that is independent of the direct wealth effect of the gamble. The
pleasure of the activity (which is itself a form of consumption) may offset the need she
might otherwise feel for a positive risk premium. A wealthy investor might be more
willing to participate in fair games and gambles which affect only a small proportion of his
wealth. In contrast, a less wealthy individual may be unwilling to participate in fair
games and gambles even if this involves only a relatively small proportion of this wealth.

Another possible explanation is that the lottery (and, to a lesser extent, betting of most
kinds) is an asymmetric gamble. Ms G places at risk a relatively small amount of her
wealth in exchange for a small probability of winning a much larger amount of wealth.
To use more technical language, the gamble is positively skewed. If she values positive
skewness (rather than simply being averse to variance), then she might be willing to
forego a positive risk premium in exchange for the increased skewness associated with
the gamble. Notice that, in the case of insurance, the gamble has negative skewness (if
my house burns down, I suffer a large loss), which would reinforce my desire for a
positive risk premium. There are other ways of getting across the same idea, for
example by assuming that investors are ‘loss-averse’ rather than risk averse.

2) We expect risky investments to earn a positive risk premium, but the actual return on
this investment has been negative every year, even before taking into account the
(positive) risk-free rate, so my realised excess return has definitely been negative.
Remember, though, that we defined risk aversion in terms of expected excess returns.
It is possible that I believe that, over my planned investment horizon, I will earn a
positive excess return on this investment. If so, then my decision to hold onto the units
may be consistent with risk aversion. However, we would have to consider the
possibility that this particular unit trust manager has negative skill (i.e. is an idiot), in
which case it would make sense to take the money out. It is difficult to assess that with
only 3 annual observations, and it might be that the whole market has fallen over that
period, so that our manager’s performance is consistent with that of his peers.

This also tells us something about the dangers of trying to estimate expected excess
returns by looking at realised returns over some sample period. If the period is too short

1
 (or the expected returns are not constant), looking at what happened during the sample
period may not tell us much about the information investors are using to make their
decisions.

Finally, it might be worth noting the connection between this problem and the more
general problem of valuing companies. Many companies that have yet to earn a profit
have positive market values. Many more have market values that seem difficult to
explain in terms of the relatively small or negative earnings they have generated to date
(al lot of technology stocks fall into this category). This can only make sense if investors’
expectations of future earnings (or, alternatively, of future required rates of return) are
significantly different than current experience; otherwise, the stocks are overvalued. But
how are we to arrive at a sensible, independent view of what expectations are
warranted?

3)
a) First calculate the expected utility from no insurance:
E[U(W)]  i Probi  U(Wi )  10.29 (=0.1×U(50000) + 0.1×U(1) + 0.8×U(100000) =
0.1×ln(50000) + 0.1×ln(1) + 0.8×ln(100000)

Now the certainty equivalent wealth:

ln(W CE) = 10.29 so, W CE = £29,505

So prepared to pay up to £100,000 − £29,505 = £70,495 for insurance

b) A risk neutral insurance company will have a minimum premium equal to the
actuarial value of its expected loss:
E(loss)  W0  i probi  Wi  £100,000  £85,000.1  £14,999.9
Hence the insurance company’s minimum premium will be £14,999.90

c) This difference between the insurer’s minimum and the insured’s maximum
premium place bounds on the price of insurance
i) The price of the insurance is ambiguous because we do not know
the true utility function of the insurance company. In reality, it is
likely to be risk averse, and may be as risk averse as the investor.
ii) Insurance company can charge maximum willingness to pay and
earn monopoly rents.
iii) Competition in insurance drives companies’ profits to zero and
premium towards actuarial value.

4) a) Let w denote the proportion in the risky fund and call the fund a.
E(Rp) = w E(Ra) + (1-w) Rf = 0.7 x 0.17 + 0.3 x 0.07 = 0.14 = 14%
P = w a = 0.7 x 0.27 = 0.189 = 18.9%
b) The portfolio is: 0.3 Rf + 0.7 {0.27 A + 0.33B + 0.40C}
the proportions are: 0.7x0.27 = 0.189, 0.231 and 0.28 respectively, or 18.9%,
23.1% and 28% (adding up to 0.7)
c) Assume that the revised portfolio should retain the risk of the specialised one
then the new proportion in the risk index fund (y) must be: 0.189 = 0.25 y so y = 0.756.
This portfolio will have an expected return of 0.756 * 0.13 + 0.244 * 0.07 = 0.115.
Thus the investor’s return would drop by 0.14-0.115 = 0.025 (2.5%) which would be the
maximum additional charge that the broker could levy.

5) With N assets, portfolio variance is defined as:

N N N N
 P2   i2 i2   i j ij   i2 2
i 1 i 1 j 1 i 1
j i
2
 The simplification arises because the assets are independent, which eliminates the
terms involving ij, and have the same variances, which removes the subscripts on .To
find the point with minimum variance, set up a Lagrangean and differentiate:

N
M in Z    i2 2
i 1
N
 N 
Z    i2 2      i  1
i 1  i 1 

Z
 2 i 2    0  2 i 2  
 i
Z
  i  1  0
 i

If we take the ratio of the partial derivatives for any pair of i (call them i and j) this is:

2i 2 
  i   j
2 j 2 

Thus all of the x values are equal and the minimum variance portfolio has portfolio
weights:
i = 1/N

Because the expected return is constant, all risk averse investors will choose this
portfolio.

6) (a) First note that  BS   B S  BS  .15.3.1  .0045 .

To find the proportion of wealth that needs to be invested into S to obtain the minimum
variance portfolio P*, minimise the variance of the portfolio; i.e.,
 Differentiate the variance with respect to S,
 Set the derivative equal to 0,
 Solve for S.

The minimum variance portfolio is found by applying the formula:

S  2
 B2   BS

.152  .0045
 .1739
 S   B2  2 BS .32  .152  2.0045

 B  1   S  .8261

The mean and standard deviation of the minimum variance portfolio equal:

ERP*    S ERS    B ERB   .1739.2  .8261.12  .1339

3
 
 P   S2 S2   B2  B2  2 S  B SB 
12


 P  .17392 .32  .82612 .152  2.1739.8261.0045 
12
 .1392

(b) The easiest way to answer this question is to do the calculations in a spreadsheet like
Excel:

Investment Investment Expected Standard

weight in stocks weight in bonds return deviation
0 1 0.12 0.15
0.1739 0.8261 0.1339 0.1392 Minimum variance portfolio P*
0.2 0.8 0.136 0.1394
0.4 0.6 0.152 0.157
0.4516 0.5484 0.1561 0.1654 Tangency portfolio T
0.6 0.4 0.168 0.1953
0.8 0.2 0.184 0.2448
1 0 0.2 0.3

(c) The graph approximates the points .16 (expected return) and .16 (SD) for the tangency
portfolio.

0.25

S
0.20

T
0.1561
0.15
Expected Return

P*
B

0.10

RF

0.05

0.00
0.00 0.05 0.10 0.15 0.1654 0.20 0.25 0.30 0.35
Standard Deviation

(d) The point is to find S and B that yield the highest expected Sharpe ratio (S and B are
the proportions of wealth that need to be invested in S and B to obtain T).

 E RT   R f 
The objective is therefore to Max  .
 S   T 

where E RT    S E RS   1   S E RB 


 T   S2 S2  1   S 2  B2  2 S 1   S  SB 12

4
   S E RS   1   S E RB   R f 
So we need to Max  .
S

  2 2  1   2  2  2 1   
 S S S B S S SB 
12



To find S,
 differentiate the expected Sharpe ratio with respect to S,
 set the derivative equal to 0,
 solve for S.

The proportion of stocks in the tangency portfolio is given by:

S 
E RS   R f  B2  E RB   R f  BS
ERS   R f  B2  ERB   R f  S2  ERS   R f  ERB   R f  BS
S 
.2  .08.0225  .12  .08.0045  .4516
.2  .08.0225  .12  .08.09  .2  .08  .12  .08.0045
 B  1   S  .5484

The mean and standard deviation of the tangency portfolio are:

ERT    S ERS    B ERB   .4516.2  .5484.12  .1561


 T   S2 S2   B2  B2  2 S  B SB 12


 T  .45162 .32  .54842 .152  2.4516.5484.0045 
12
 .1654

(e) The reward-to-variability ratio of the best feasible CAL (Capital allocation line) is:
E RT   R f .1561  .08
  .4601
T .1654

(f) (i) If you require your combined portfolio C to yield a mean return of 14% you can find the
corresponding standard deviation from the best feasible CAL. The formula for this CAL
is:

E RT   R f
E RC   R f   C  .08  .4601 C  .14 . Therefore, C = .1304.
T

(ii) To find the proportion invested in T-bills we need to remember that the mean of the
complete portfolio, .14, is an average of the T-bill rate and the tangency portfolio T. Let y
be the proportion in T. The mean of any portfolio along the best feasible CAL is:

 
ERC   1  y R f  yE RT   R f  y ERT   R f  .08  y.1561  .08  .14

We find y = .7884 and 1-y = .2116, the proportion in T-bills. To find the proportions
invested in each of the funds, we multiply .7884 by the proportions of the stocks and
bonds in the tangency portfolio:

Proportion of stocks in C = .7884.4516  .356

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 Proportion of bonds in C = .7884.5484  .4324

0.21

0.2 S

0.19

0.18

0.17

0.16

0.15
C
Expected Return

0.14 D

0.13

0.12 B

0.11

0.1

0.09

0.08

0.07

0.06
.1413
0.05
.1304
0 0.05 0.1 0.15 0.2 0.25 0.3 0.35
Standard Deviation

(g) Using only the stock and bond funds to achieve a portfolio mean of .14, we must find
the appropriate proportion in the stock fund, S, and B = 1-S in the bond fund. The
portfolio mean will be:

ERD    S ERS    B ERB   .2 S  .121   S   .14 . Therefore, S = .25.

So the proportions will be 25% in stocks and 75% in bonds. The standard deviation of
this portfolio will be:


 D   S2 S2   B2  B2  2 S  B SB 
12


 D  .252 .32  .752 .152  2.25.75.0045 
12
 .1413

This is considerably larger than the standard deviation of 13.04% achieved using T-bills
and the tangency portfolio. This suggests that capital markets (i.e., the presence a risk-
free rate at which we can borrow and lend) increase efficiency: For the same average
return, we bear much less risk in part (f)(i).

(h) With no opportunity to borrow you wish to construct a portfolio with a mean of 0.24.
Since this exceeds the mean on stocks of 0.20, you will have to go short bonds, which
have a mean of 0.12, and use the proceeds to buy additional stocks. The graphical
representation of your risky portfolio is point E on the following graph:

Point E is the stock/bond combination with mean of .24. Let S be the proportion of stocks and
1-S be the proportion of bonds required to achieve the .24 mean. Then:

ERE    S ERS    B ERB   .2 S  .121   S   .24 .

6
Therefore, S = 1.5 and B = -0.5.
0.3

0.25 G E
0.24

0.2
S
Expected Return

0.15 T

0.1

0.05

0
0 0.1 0.2 0.3 0.3478 0.4 0.4487 0.5 0.6
Standard Deviation

You would have to sell short an amount of bonds equal to .5 of your total funds, and
invest 1.5 times your total funds in stocks. The standard deviation of this portfolio is:


 E   S2 S2   B2  B2  2 S  B SB 
12


 E  1.52 .32   .52 .152  21.5 .5.0045  12
 .4487

If you were allowed to borrow at the risk-free rate of .08, the way to achieve the
target .24 would be to invest more than 100% of your funds in the tangency portfolio,
moving out along the highest feasible CAL to the right of T, up to G, on the graph above.

G is the point on the best feasible CAL which has a mean of .24. Using the formula for
the best feasible CAL we can find the corresponding standard deviation:

E RT   R f
E RG   R f   G  .08  .4601 G .24 . Therefore, G = .3478,
T

which is considerably less than the .4487 standard deviation you would get without the
possibility of borrowing at the risk-free rate of .08.

What is the portfolio composition of point G on the best feasible CAL? The mean of any
portfolio along this CAL is:


ERG   1  y R f  yE RT   R f  y ERT   R f  .08  y.1561  .08  .24 
where y is the proportion invested in the tangency portfolio T. So, y = 2.1025. This
means that for every £1 of your own funds invested in portfolio T, you borrow an
additional £1.1025 and invest it also in portfolio T.