Bridge program, Summer 2005

Finance module, Solutions to assignment 6

Solutions to assignment 6: Equilibrium in asset markets

2 1. Recall that i = mi /m , where i is the beta of asset i, mi is the covariance of asset i and 2 is the variance of the market. ther market, and m 2 We know m = 0.22 , and if we recall that im = i m im , where im denotes the correlation of asset i with the market, its immediate that we can solve for the correlation from the information on i .

For example, for LNUX we have: 0.15 = 0.2 0.6 LNUX,M ; 0.22 LNUX,M = 0.05

where I use LNUX,M to denote the correlation between LNUX and the Market. Similarly one can nd that MSFT,M = 0.8. 2. We can apply our standard formula for the standard deviation of a portfolio to nd the answer: i = (0.22 0.992 + 0.62 0.012 + 2(0.99)(0.01)0.2(0.6)0.05)1/2 = 19.84% ii = (0.22 0.992 + 0.32 0.012 + 2(0.99)(0.01)0.2(0.3)0.80)1/2 = 20.04% iii = 20% Note that combining LNUX with the Market yields a portfolio that has less risk than combining MSFT with the market, even though MSFT has a lower standard deviation. The intuition is that LNUX has a lower correlation with the market, and therefore is a better security for diversication. 3. Note that the standard deviation when the 1% was invested in the risk-free asset is simply p = 0.99 0.20 = 19.8%. The following table records the previous information. Strategy with 1% in LNUX MSFT Market SD[rp] 19.84% 20.04% 20.00% Increase in SD 0.0391% 0.2408% 0.20%

The suggestion in the question yields the following equilibrium condition: 0.01(E[RLNUX ] Rf ) 0.01(E[RMSFT ] Rf ) 0.01(E[Rm ] Rf ) = = = 0.000391 0.002408 0.0020 which can be rearranged as: E[RLNUX ] = Rf + E[rMSFT ] = Rf + 0.0391 (E[Rm ] Rf ) Rf + 0.19(E[Rm ] Rf ) 0.2 0.2408 (E[Rm ] Rf ) Rf + 1.2(E[Rm ] Rf ) 0.2 Pr. Diego Garc a

Tuck School of Business at Dartmouth

Bridge program, Summer 2005

Finance module, Solutions to assignment 6

Note that 0.19 and 1.2 are (almost) the betas for these two stocks! Therefore the above two equations are almost the basic CAPM pricing equation: E[RP ] = Rf + p (E[Rm ] Rf ) Ill let you try the same exercise for an amount 0.01% of your portfolio holdings (instead of 1%) and see what happens (basically the numbers become exact - see spreadsheet).

Tuck School of Business at Dartmouth

Pr. Diego Garc a