Bridge program, Summer 2005

Finance module, Solutions to assignment 5

Solutions to assignment 5: optimal portfolio choice

1. Combining a risky and riskless asset. (a) For the expected return we have: E[RP ] = 0.2w + 0.08(1 w) = 0.08 + 0.12w. For the variance: Var[RP ] = w2 (0.30)2 p = 0.3|w|. (b) For w < 0 we are short in the risky asset (i.e. we are selling it). For w < 1 we are lending (i.e. buying the risk-free asset). For w > 1 we are borrowing (i.e. selling the risk-free asset). (c) Figure 1 gives the mean-variance ecient frontier. Note that in this case (that is, with one risky asset and a riskless asset) it is a straight line.

Figure 1: The graph presents the risk-return possibilities with the two assets. We can given the explicit relationship between P and E (RP ) by noting that the standard deviation formula implies that w = P /0.3, and putting this expression in the expected return formula we get E[RP ] = 0.08 + 0.12w = 0.08 + 0.4P i.e. the expected return is a linear function of the standard deviation of the portfolio, with slope 0.4. (d) The set of portfolios that are mean-variance ecient are those that generate the higher portion of the straight line. These portfolios satisfy w 0, i.e. the ecient portfolios will not short the risky asset. 2. Combining two risky assets. (a) Let w be the weight in Stock A, so that (1 w) is the weight in Stock B. Then as before: E[RP ] = 0.20w + (1 w)0.25 = 0.25 0.05w.

Tuck School of Business at Dartmouth

Pr. Diego Garc a

Bridge program, Summer 2005

Finance module, Solutions to assignment 5

For the variance calculation we need some more work: Var(RP ) = w2 (0.30)2 + (1 w)2 (0.40)2 + 2w(1 w)(0.30)(0.40)0.5; So that: p = w2 (0.30)2 + (1 w)2 (0.40)2 + 2w(1 w)(0.30)(0.40)0.5 (b) Figure 2 presents the plot of the mean-variance combinations of dierent portfolios with w [1, 2]. The following table gives some numerical values. Weight w 0.000 0.100 0.200 0.300 0.400 0.500 0.600 0.700 0.800 0.900 1.000 E[RP ] 0.250 0.245 0.240 0.235 0.230 0.225 0.220 0.215 0.210 0.205 0.200 p 0.400 0.376 0.354 0.334 0.317 0.304 0.295 0.289 0.288 0.292 0.300

Figure 2: The graph presents the risk-return possibilities with the two risky assets. One can actually be more explicit about the relationship between P and E[RP ] simply by solving from the expected return equation for w: E[RP ] = 0.25 0.05w w = 5 20E (RP )

and then using this expression in the standard deviation formula: P = (5 20E (RP ))2 (0.30)2 + (20E (RP ) 4)2 (0.40)2 + 2(5 20E (RP ))(20E (RP ) 4)(0.30)(0.40)0.5

The spreadsheet uses this expression to plot the ecient frontier. (c) Roughly, for w > 0.8 (note that in the previous table we see that the variance starts increasing after w = 0.8 and the expected return decreasing) we get that the standard deviation of the portfolios increases and the expected return decreases, i.e. we are at the lower portion of the hyperbola. Therefore all portfolios with w < 0.81 are mean-variance ecient.
1 If

you want to be precise w < 0.77 is a more exact answer.

Tuck School of Business at Dartmouth

Pr. Diego Garc a

Bridge program, Summer 2005 3. Two-risky assets and a riskless asset.

Finance module, Solutions to assignment 5

(a) We should choose the asset with the highest Sharpe ratio. When Rf = 10% the Sharpes ratios are: E[rA ] Rf 0.2 0.1 sA = = = 0.33; A 0.3 sB = 0.25 0.10 E[rB ] Rf = = 0.37; B 0.4

so that stock B is the better choice. When Rf = 4% we get sA = 0.533 and sB = 0.525, so that stock A is a better choice. (b) We need to maximize the Sharpe ratio once again, now over all possible portfolios. That is: max
w

E[RP ] Rf . p

Solving the above optimization problem numerical you ought to nd that the optimal portfolio of risky assets is w = 0.483 and (1 w) = 0.517. Any investor, whatever his risk tolerance, should invest into this portfolio of risky stocks, and the risk-free asset. The relative amounts put into the risk-free asset and this risky portfolio (which invests 48.3% in A and 51.7% in B) depend on the risk tolerance of the investor.

Tuck School of Business at Dartmouth

Pr. Diego Garc a