Portfolio Management

Tutorial 4
&
Chapter 4 Calculation
Portfolio Management
Tutorial 4
 Q1. What is covariance, and why is it important
in portfolio theory?

Covariance is a measure of the degree to which two variables “move together” relative to their individual mean
values over time. The formula of covariance are :

Covariance is important because it is used in portfolio theory to determine what assets to include in the portfolio.
Covariance is a statistical measure of the directional relationship between two asset prices. Modern portfolio
theory uses this statistical measurement to reduce the overall risk for a portfolio and diversify their portfolio. The
lower the covariance, the better the diversification effect. A positive covariance means that assets generally move
in the same direction while negative covariance moves in the opposite direction.
 Q2. Why do most assets of the same type show positive covariances of
returns with each other? Would you expect positive covariances of returns
between different types of assets such as returns on Treasury bills, General
Electric common stock, and commercial real estate? Why or why not?

Similar assets such as common stock or stock for a company in the same industry will have high positive
covariance because their numbers (profit and sales) are affected by common factors, for example if the oil starts
to run out all the oil company's profits and therefore, the risk will be affected in a similar way. As the profit and risk
factors tend to move together, you should expect the stock returns to also move together and have high
covariance.

You should not expect a positive covariance of returns between different types of assets because the return will
not be as correlated. This is even more for the investment in different countries where the return and risk are
different and very unique and they may not share the same risk factors.
 Q3. What is the relationship between
covariance and the correlation coefficient?

The covariance between the returns of assets i and j is affected by the variability of these two returns. Therefore, it is difficult to
interpret the covariance figures without taking into account the variability of each return series. The correlation coefficient is obtained
by standardizing (dividing) the covariance by the product of the individual standard deviations.

Formula of correlation coefficient:

The coefficient can only vary in the range of +1, which indicates positive correlation to -1, which indicates negative correlation.
Positive correlation (+1) means that the returns for the two assets move together in a positively and completely linear manner.
Negative correlation (-1) means that the returns for two assets move together in a completely linear manner but in the opposite
direction.
Q4. Draw a properly labeled graph of the Markowitz efficient
frontier. Describe the efficient frontier in exact terms. Discuss the
concept of dominant portfolios, and show an example of one on
your graph.

The efficient frontier represents that set of portfolio with the maximum rate of
return for every given level of risk or the minimum risk for every level of return.
Every portfolio that lies on the efficient frontier has either a higher rate of return
for the same risk level or lower risk for an equal rate of return than some
portfolio falling below the frontier.

Dominant portfolio is a portfolio that has the highest expected return for a given
level of risk, or the lowest risk for a given level of expected return, when
compared to other portfolios. An example of a dominant portfolio in the graph is
point A and point B.
Q5. Why are investors’ utility curves important
in portfolio theory?

Investors’ utility curves are important because they specify the trade-offs the
investors are willing to make between the expected return and risk. The slope of the
efficient frontier curve decreases steadily as the investors move upward by taking
more risk. The interactions of these two curves will determine the particular
portfolio selected by the investors. An optimal portfolio has the highest utility for
the given investors. The optimal lies at the point of tangency between the efficient
frontier and the utility curve with the highest possible utility.

Investor X with the set of utility curves will achieve the highest utility by investing
the portfolio at X. Investor Y, with a different set of utility curves will achieve the
highest utility by investing the portfolio at Y. Investor X is more risk averse because
investor X takes lower risk than investor Y.
 Q6. Explain how a given investor chooses an optimal portfolio.
Will this choice always be a diversified portfolio, or could it be
a single asset? Explain your answer.

Is a point of tangency between his set of utility curve and the efficient frontier because it could be a
diversified portfolio which can generate minimum variance and the maximize portfolio return. In my
opinion, investors will choose a diversified portfolio. The purpose of diversification is to reduce the
standard deviation of the total portfolio. This is because it contains all risky assets, it is a
completely diversified portfolio, which means that all the unique risk of individual assets
(unsystematic risk) is diversified away.
Q7.

Stocks K, L, and M each has the same

expected return and standard
deviation. The correlation coefficients
between each pair of these stocks are:

K and L correlation coefficient =

+0.8

K and M correlation coefficient

= +0.2 The stock L and M with -0.4 correlation coefficient
have the lowest standard deviation. It is because low
L and M correlation coefficient =
correlation reduces the portfolio risk while not
−0.4
affecting the expected return.
Given these correlations, a
portfolio constructed of which
pair of stocks will have the
lowest standard deviation?
Explain.
 E(Rp) = Σ[E(Ri) x 𝒲i]

Q8. = (0.15) (0.5) + (0.20) (0.5)

= 0.175 // 17.5%
You are considering two assets
with the following characteristics.
If r₁,₂ = 0.40,

E(R1) = 0:15 E(σ1) = 0:10 w1 = 0:5 Standard deviation, σp =√ (𝒲₁² σ₁² + 𝒲₂² σ₂² + 2 𝒲₁𝒲₂ ρ₁,₂ σ₁σ₂)

= √ [(0.5)² (0.10)² + (0.5)² (0.20)² + 2(0.5)(0.5) (0.10)(0.20)(0.40)]

E(R2) = 0:20 E(σ2) = 0:20 w2 = 0:5
= √ (0.0165)

= 0.1285 // 12.85%
Compute the mean and standard
deviation of two portfolios if r1,2 =
If r₁,₂ = -0.60,
0.40 and −0.60, respectively. Plot
the two portfolios on a risk–return Standard deviation, σp =𝒲₁² σ₁² + 𝒲₂² σ₂² + 2 𝒲₁𝒲₂ ρ₁,₂ σ₁σ₂
graph and briefly explain the
= √ [(0.5)² (0.10)² + (0.5)² (0.20)² + 2(0.5)(0.5) (0.10)(0.20)(-0.60)]
results.
= √ (0.0065)

= 0.0806 // 8.06%
Q9. The following are monthly percentage price changes for
four market indexes
a. Average monthly rate of return for each index

Month DJIA S&P 500 Russell 2000 Nikkei

1 0.03 0.02 0.04 0.04

2 0.07 0.06 0.1 -0.02

3 -0.02 -0.01 -0.04 0.07

4 0.01 0.03 0.03 0.02

5 0.05 0.04 0.11 0.02

6 -0.06 -0.04 -0.08 0.06

Mean 0.013333 0.016667 0.026667 0.031667

b. Standard deviation for each index

Month DJIA DJIA DJIA

Market Index Market Index (Ri - mean Ri)2
(Ri) (Ri - mean Ri)

1 0.03 0.017 0.000289

2 0.07 0.057 0.003249

3 -0.02 -0.033 0.001089

4 0.01 -0.003 0.000009

5 0.05 0.037 0.001369 Variance = 0.011334 / (6-1) = 0.0023

6 -0.06 -0.073 0.005329
Standard deviation = (0.0023)1/2 = 0.0476 @ 4.76%
Mean 0.013 SUM=0.011334
b. Standard deviation for each index cont.

Month S&P 500 S&P 500 S&P 500

Market Index Market Index (Ri - mean Ri)2
(Ri) (Ri - mean Ri)

1 0.02 0.003 0.000009

2 0.06 0.043 0.001849

3 -0.01 -0.027 0.000729

4 0.03 0.013 0.000169

5 0.04 0.023 0.000529

Variance = 0.006534 / (6-1) = 0.0013
6 -0.04 -0.057 0.003249

Mean 0.017 SUM=0.006534 Standard deviation = (0.0013)1/2 = 0.0361 @ 3.61%

b. Standard deviation for each index cont.

Month Russell 2000 Russell 2000 Russell 200

Market Index Market Index (Ri - mean Ri)2
(Rj) (Rj - mean Rj)

1 0.04 0.013 0.000169

2 0.10 0.073 0.005329

3 -0.04 -0.067 0.004489

4 0.03 0.003 0.000009

5 0.11 0.083 0.006889

Variance = 0.028334 / (6-1) = 0.0057
6 -0.08 -0.107 0.011449

Mean 0.027 SUM=0.028334 Standard deviation = (0.0057)1/2 = 0.0753 @ 7.53%

b. Standard deviation for each index cont.

Month Nikkei Nikkei Nikkei

Market Index Market Index (Ri - mean Ri)2
(Rj) (Rj - mean Rj)

1 0.04 0.008 0.000064

2 -0.02 -0.052 0.002704

3 0.07 0.038 0.001444

4 0.02 -0.012 0.000144

5 0.02 -0.012 0.000144

Variance = 0.005284 / (6-1) = 0.0011
6 0.06 0.028 0.000784

Mean 0.032 SUM=0.005284 Standard deviation = (0.0011)1/2 = 0.0325 @ 3.25%

c. Covariance between the rates of
return for the following indexes:

DJIA – S&P 500

DJIA – S&P 500
S&P 500 – Russell 2000

S&P 500 – Nikkei Month DJIA S&P 500 DJIA S&P 500 [(Ri - mean Ri) x (Rj
Market Market Market Index Market Index - mean Rj)]
Index Index (Ri - mean Ri) (Rj - mean Rj)
Russell 2000 – Nikkei (Ri) (Rj)

1 0.03 0.02 0.017 0.003 0.000051

2 0.07 0.06 0.057 0.043 0.002451

3 -0.02 -0.01 -0.033 -0.027 0.000891

4 0.01 0.03 -0.003 0.013 -0.000039

5 0.05 0.04 0.037 0.023 0.000851

6 -0.06 -0.04 -0.073 -0.057 0.004161

Mean 0.013 0.017 sum = 0.00839

Cov (DJIA, S&P 500) = 0.00839 / 5 = 0.001678

c. Covariance between the rates of
return for the following indexes:

DJIA – S&P 500

S&P 500 – Russell 2000
S&P 500 – Russell 2000
Month S&P 500 Russell S&P 500 Russell 2000 [(Ri - mean Ri) x (Rj
S&P 500 – Nikkei Market 2000 Market Index Market Index - mean Rj)]
Index Market (Ri - mean Ri) (Rj - mean Rj)
(Ri) Index
Russell 2000 – Nikkei (Rj)

1 0.02 0.04 0.003 0.013 0.000039

2 0.06 0.10 0.043 0.073 0.003139

3 -0.01 -0.04 -0.027 -0.067 0.001809

4 0.03 0.03 0.013 0.003 0.000039

5 0.04 0.11 0.023 0.083 0.001909

6 -0.04 -0.08 -0.057 -0.107 0.006099

Mean 0.017 0.027 sum = 0.01302

Cov (S&P 500, Russell 2000) = 0.01302 / 5 = 0.002604

c. Covariance between the rates of
return for the following indexes:

DJIA – S&P 500

S&P 500 – Nikkei
S&P 500 – Russell 2000

S&P 500 – Nikkei Month S&P 500 Nikkei S&P 500 Nikkei [(Ri - mean Ri) x (Rj
Market Market Market Index Market Index - mean Rj)]
Index Index (Ri - mean Ri) (Rj - mean Rj)
Russell 2000 – Nikkei (Ri) (Rj)

1 0.02 0.04 0.003 0.008 0.000024

2 0.06 -0.02 0.043 -0.052 -0.002236

3 -0.01 0.07 -0.027 0.038 -0.001026

4 0.03 0.02 0.013 -0.012 -0.000156

5 0.04 0.02 0.023 -0.012 -0.000276

6 -0.04 0.06 -0.057 0.028 -0.001596

Mean 0.017 0.032 sum = -0.00527

Cov (S&P 500, Nikkei) = -0.00527 / 5 = -0.001054

c. Covariance between the rates of
return for the following indexes:

DJIA – S&P 500

Russell 2000 – Nikkei
S&P 500 – Russell 2000
Month Russell Nikkei Russell 2000 Nikkei [(Ri - mean Ri) x (Rj
S&P 500 – Nikkei 2000 Market Market Index Market Index - mean Rj)]
Market Index (Ri - mean Ri) (Rj - mean Rj)
Index (Rj)
Russell 2000 – Nikkei (Ri)

1 0.04 0.04 0.013 0.008 0.000104

2 0.10 -0.02 0.073 -0.052 -0.003796

3 -0.04 0.07 -0.067 0.038 -0.002546

4 0.03 0.02 0.003 -0.012 -0.000036

5 0.11 0.02 0.083 -0.012 -0.000996

6 -0.08 0.06 -0.107 0.028 -0.002996

Mean 0.027 0.032 sum = -0.01027

Cov (S&P 500, Nikkei) = -0.00527 / 5 = -0.002054

d. The correlation coefficients for the same four combinations

Correlation coefficients
ρij = COV / σi σj

Correlation, ρ(DJIA, S&P) = 0.001678 / [(0.0476)(0.0361)] = 0.9765

Correlation, ρ(S&P, R2000) = 0.002604/ [(0.0361)(0.0753)] = 0.9579

Correlation, ρ(S&P, Nikkei) = -0.001054/ [(0.0361)(0.0325)] = -0.8984

Correlation, ρ(R2000, Nikkei) = -0.002054/ [(0.0753)(0.0325)] = -0.8393

e. Using the answers from parts (a), (b), and (d), calculate the expected return and standard
deviation of a portfolio consisting of equal parts of

(1) the S&P and the Russell 2000 and

Portfolio expected return = (0.5)(0.016667)+(0.5)(0.026667)

= 0.021667

Portfolio Standard deviation

=√(0.5)²(0.0361)²+(0.5)²(0.0753)²+2(0.5)(0.5)(0.002604)

=0.05518

(2) the S&P and the Nikkei.

Portfolio expected return = (0.5)(0.017) + (0.5)(0.032)

= 0.0245

Portfolio Standard deviation

= √(0.5)²(0.0361)²+(0.5)²(0.0325)²+2(0.5)(0.5)(-0.001054)(0.0361)(0.0325)

= 0.009875

Discuss the two portfolios.

The S&P and Nikkei portfolio has higher expected return with lower standard deviation, which means a lower risk. Choose second
Chapter 4 : Portfolio
Management (Calculation)
Q1.

Considering the world economic

outlook for the coming year and
estimates of sales and earnings in the Probability Possible Return Expected Return
pharmaceutical industry, you expect
0.10 −0.20 -0.0200
the rate of return for Lauren Labs
common stock to range between −20 0.15 −0.05 -0.0075
percent and +40 percent with the
following probabilities: 0.20 0.10 0.0200

0.25 0.15 0.0375

Probability Possible Returns
0.10 −0.20 0.20 0.20 0.0400
0.15 −0.05
0.20 0.10 0.10 0.40 0.0400
0.25 0.15
E(Ri) = 0.1100 (11%)
0.20 0.20
0.10 0.40

Compute the expected rate of return

for Lauren Labs.
 Q2.

Given the following market values of

Market Value ($ Wi Wi*E(Ri)
stocks in your portfolio and their Stock E(Ri)
millions)
forecasted rates of return, what is the
expected rate of return for your Disney $15,000 0.14 0.16 0.0224
common stock portfolio? Starbucks 17,000 −0.14 0.18 -0.0252

Harley 0.34 0.0612

Stock Market Value ($ millions) E(Ri) 32,000 0.18
Davidson
Disney $15,000 0.14 Intel 23,000 0.16 0.24 0.0384
Starbucks 17,000 −0.14 Walgreens 7,000 0.12 0.07 0.0084

Harley Davidson 32,000 0.18 Total 94,000 0.1052

Intel 23,000 0.16

Walgreens 7,000 0.12 Expected rate of return portfolio is 0.1052/ 10.52%
 W E(R) W x E(R)
Q3.
0.6 0.10 0.06
Given: 0.4 0.15 0.06

E(R1) = 0.10 ΣW x E(R) = 0.12 E(R) of portfolio = 0.12 = 12%

E(R2)= 0.15
σ
1= 0.03
σ
2= 0.05
Calculate the expected returns and
standard deviations of a two-stock
portfolio in which Stock 1 has a weight
of 60 percent under each of the a) r1,2 = 1.00
following conditions: σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(1)(0.03)(0.05)

=√0.0014444
a. r1,2 = 1.00
b. r1,2 = 0.75 = 0.038
c. r1,2 = 0.25
d. r1,2 = 0.00 b) r1,2 = 0.75
e. r1,2 = -0.25
f. r1,2 = -0.75 σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(0.75)(0.03)(0.05)
g. r1,2 = -1.00
=√0.001264

= 0.036
Q3.

Given:

E(R1) = 0.10
E(R2)= 0.15 (c) r1,2 = 0.25
σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(0.25)(0.03)(0.05)
σ
1= 0.03
=√0.000904
σ
2= 0.05
= 0.03
Calculate the expected returns and
standard deviations of a two-stock (d) r1,2 = 0.00
portfolio in which Stock 1 has a weight σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(0)(0.03)(0.05)
of 60 percent under each of the =√0.000724
following conditions:
= 0.027
a. r1,2 = 1.00 (e) r1,2 = -0.25
b. r1,2 = 0.75
c. r1,2 = 0.25 σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(-0.25)(0.03)(0.05)
d. r1,2 = 0.00 =√0.000544
e. r1,2 = -0.25
f. r1,2 = -0.75 = 0.023
g. r1,2 = -1.00
Q3.

Given:

E(R1) = 0.10
E(R2)= 0.15 (f) r1,2 = -0.75
σ σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(-0.75)(0.03)(0.05)
1= 0.03
σ
2= 0.05 =√0.000184

Calculate the expected returns and = 0.014

standard deviations of a two-stock
portfolio in which Stock 1 has a weight
of 60 percent under each of the (g) r1,2 = -1.00
following conditions:
σ port =√0.62 0.032 +0.42 0.052 + 2(0.6)(0.4)(-1)(0.03)(0.05)
a. r1,2 = 1.00
b. r1,2 = 0.75 =√0.000004
c. r1,2 = 0.25 = 0.002
d. r1,2 = 0.00
e. r1,2 = -0.25
f. r1,2 = -0.75
g. r1,2 = -1.00
Q4. The standard deviation of Shamrock Corp. stock is 19 percent. The
standard deviation of Cara Co. stock is 14 percent. The covariance
between these two stocks is 100. What is the correlation between
Shamrock and Cara stock?

ρ (X,Y) = cov (X,Y) / σX.σY

= 100 / (19 x 14)

= 0.37
Q5. As a portfolio manager of an (i) Calculate the expected portfolio return for each of the 6 years.
investment bank, you owned three
assets that have the following annual
rates of expected return:

Expected return (%)

Year Asset L Asset M
Expected return (%) Expected portfolio return
2012 14 20
2013 14 18 Year Asset L Asset M
2014 16 16
2015 17 14 2012 14 20 (0.4x0.14)+(0.6x0.2) = 0.176
2016 17 12 2013 14 18 (0.4x0.14)+(0.6x0.18) = 0.164
2017 19 10 2014 16 16 (0.4x0.16)+(0.6x0.16) = 0.16
2015 17 14 (0.4x0.17)+(0.6x0.14) = 0.152
2016 17 12 (0.4x0.17)+(0.6x0.12) = 0.14
2017 19 10 (0.4x0.19)+(0.6x0.1) = 0.136
Q5. As a portfolio manager of an (ii) Compute the average expected portfolio returns over the 6-year period
investment bank, you owned three
assets that have the following annual
rates of expected return:
Expected return (%) Expected portfolio return (%)
Expected return (%)
Year Asset L Asset M
Year Asset L Asset M
2012 14 20 2012 14 20 (0.4x0.14)+(0.6x0.2) = 0.176
2013 14 18 2013 14 18 (0.4x0.14)+(0.6x0.18) = 0.164
2014 16 16 2014 16 16 (0.4x0.16)+(0.6x0.16) = 0.16
2015 17 14 2015 17 14 (0.4x0.17)+(0.6x0.14) = 0.152
2016 17 12
2017 19 10 2016 17 12 (0.4x0.17)+(0.6x0.12) = 0.14

2017 19 10 (0.4x0.19)+(0.6x0.1) = 0.136

Average expected portfolio returns = (0.928 / 6) = 0.1547@15.47

 (iii) Compute standard deviation of expected portfolio returns over the
Q5. As a portfolio manager of an 6-year period.
investment bank, you owned three
assets that have the following annual Expected return (%)
rates of expected return: Year Asset L Asset M Asset L Asset M
Asset L Asset M
(Ri) (Rj)
(Ri - mean (Rj - mean (Ri - mean (Rj - mean
Expected return (%)
Ri) (%) Rj) (%) Ri)2 (%) Rj)2 (%)
Year Asset L Asset M
2012 14 20 2012 14 20 -2.17 5 4.70 25
2013 14 18 2013 14 18 -2.17 3 4.70 9
2014 16 16 2014 16 16 -0.17 1 0.03 1
2015 17 14 2015 17 14 0.83 -1 0.70 1
2016 17 12 2016 17 12 0.83 -3 0.70 9
2017 19 10 2017 19 10 2.83 -5 8.02 25
Mean 16.17 15 Sum= 18.83 Sum= 70
Portfolio Standard Deviation =
Asset L
σp = √ [(17.6%-15.5%) + (16.4%-15.5%) + (16%-15.5%)^2
+ (15.2%-15.5%)^2 + (14%-15.5%)^2 + (13.6%-15.5%)^2] / Variance = 18.83 / (6-1) = 3.77%
(6-1)
Standard deviation = (3.77)1/2 = 1.94%
= √ [(2.1%)^2 + (0.9%)^2 + (0.5%)^2 + (-0.3%)^2 +
(-1.5%)^2 + (-1.9%)^2] / 5 Asset M

= √ (11.42/5) Variance = 70 / (6-1) = 14%

=1.511 Standard deviation = (14)1/2 = 3.74%
 (iv) Discuss the correlation of return of the asset L and M
Q5. As a portfolio manager of an
investment bank, you owned three Expected return (%) [Asset L(Ri - mean Ri)
Year Asset L Asset M x Asset M
assets that have the following annual Asset L Asset M
(Rj - mean Rj)]
rates of expected return: (Ri) (Rj)
(Ri - mean (Rj - mean (%)
Ri) (%) Rj) (%)
Expected return (%)
Year Asset L Asset M 2012 14 20 -2.17 5 -10.83
2013 14 18 -2.17 3 -6.5
2012 14 20 2014 16 16 -0.17 1 -0.17
2013 14 18
2015 17 14 0.83 -1 -0.83
2014 16 16
2016 17 12 0.83 -3 -2.5
2015 17 14
2017 19 10 2.83 -5 -14.17
2016 17 12
Mean 16.17 15 Sum= -35
2017 19 10

Covij = -35/ (6-1) = -7%

Correlation of return, rij = Covij / σi σj

= -7 / (1.94 x 3.74)

= -0.96

Asset L and Asset M have a perfect negative correlation which means that the two
assets move together in a completely linear manner but in an opposite direction.
 (v) Discuss the benefits of diversification achieved through
Q5. As a portfolio manager of an creation of the portfolio.
investment bank, you owned three
assets that have the following annual
rates of expected return: Diversification can reduce the risk of investment in the creation of the
portfolio. Investment which is made across different assets can reduce
Expected return (%) the impact when the market volatility drops. Thus, it reduces the risks
Year Asset L Asset M
and may also generate higher returns in the long run.
2012 14 20
2013 14 18
2014 16 16
Diversification can also help to improve long-term portfolio
2015 17 14 performance. Investors will be able to generate high returns when the
2016 17 12 market volatility has a positive impact on the stocks.
2017 19 10
 Q6. For each portfolio, calculate the risk premium per unit of risk that you
expect to receive. Assume that the risk-free rate is 3.0 percent.
You are evaluating various investment
opportunities currently available and
you have calculated expected returns
and standard deviations for five RFR = 3%
different well-diversified portfolios of
risky assets: Expected Standard Risk Premium
Portfolio Return (E(Ri)) Deviation (σ) [E(R)-RFR]/σ
Portfolio Expected Return Standard Deviation Q 7.80% 10.50% 0.4571
Q 7.8% 10.5%
R 10.0 14.0 R 10% 14% 0.5000
S 4.6 5.0
T 11.7 18.5 S 4.60% 5% 0.3200
U 6.2 7.5
T 11.70% 18.50% 0.4703

U 6.20% 7.50% 0.4267

 Q6. (i) Using your computations in part (a), explain which of these five portfolios
is most likely to be the market portfolio. Use your calculations to draw the
You are evaluating various investment capital market line (CML).
opportunities currently available and
The CML slope is known as the ratio of risk premium per unit of risk. Since
you have calculated expected returns portfolio R has the highest ratio, 50%, among these five portfolios, it is most
and standard deviations for five likely to be the market portfolio. The y-intercept is 3%, the risk free rate.
different well-diversified portfolios of
risky assets:

Portfolio Expected Return Standard Deviation

Q 7.8% 10.5%
R 10.0 14.0
S 4.6 5.0
T 11.7 18.5
U 6.2 7.5
 Q6.

You are evaluating various investment

opportunities currently available and
you have calculated expected returns
and standard deviations for five (ii) If you are only willing to make an investment with σ=7 percent
different well-diversified portfolios of , is it possible for you to earn a return of 7.0 percent?
risky assets:
If the standard deviation = 7%,
Portfolio Expected Return Standard Deviation
Q 7.8% 10.5% expected portfolio return
R 10.0 14.0 E(Rp) = 0.03 + (0.50) (0.07)
S 4.6 5.0
= 0.065 // 6.5%
T 11.7 18.5
U 6.2 7.5
Thus, the answer is no, it is not possible to earn an expected
return of 7% with a portfolio whose standard deviation is 7%.
 (iii) What is the minimum level of risk that would be necessary for an investment to earn 7.0
percent? What is the composition of the portfolio along the CML that will generate that
Q6.
expected return?

You are evaluating various investment E(Rp) = 7%

opportunities currently available and 7% = 3% + (0.50) σp
you have calculated expected returns σp = 4% / 0.50 = 8%
and standard deviations for five
: The standard deviation of 8% is consistent with an expected return of 7%.
different well-diversified portfolios of
risky assets: Since the covariance between the risk-free asset and the market portfolio is zero.
Thus, to find the portfolio weights, the portfolio standard deviation calculation
simplifies as:
Portfolio Expected Return Standard Deviation
Q 7.8% 10.5% σp =𝒲₁² σ₁² + 𝒲₂² σ₂² + 2 𝒲₁𝒲₂ ρ₁,₂ σ₁σ₂
R 10.0 14.0 σp = 𝒲₁² σ₁² + 𝒲₂² σ₂ + 0
S 4.6 5.0 σp = 𝒲m (σm) and the weight of the risk-free asset, 𝒲rf = 1 - 𝒲m.
T 11.7 18.5
U 6.2 7.5
As σp = 8%; σm = σR = 14%,
8% = 𝒲m (14%)
𝒲m = 8% / 14% = 0.5714
𝒲rf = 1 – 0.5714 = 0.4286

: The composition is 42.86% in the risk-free asset and 57.14% in the market portfolio
that makes the portfolio expected return to 7%.

As a check, the weighted average expected return should equal 7%:

E(Rp) = Wm * E(Rm) + Wrf * E(Rf)
0.5714 (10%) + 0.4286 (3%) = 7.0%.
 Q6. (iv) Suppose you are now willing to make an investment with σ=18.2 percent. What would
be the investment proportions in the riskless asset and the market portfolio for this
portfolio? What is the expected return for this portfolio?
You are evaluating various investment
opportunities currently available and Since the covariance between the risk-free asset and the market portfolio is zero.
Thus, the portfolio standard deviation calculation can be simplified to:
you have calculated expected returns
and standard deviations for five
σp = 𝒲m (σm) and the weight of the risk-free asset, 𝒲rf = 1 - 𝒲m.
different well-diversified portfolios of
risky assets: As σp = 18.2%, σm = σR = 14%,
18.2% = 𝒲m (14%)
𝒲m = 18.2% / 14% = 1.30
Portfolio Expected Return Standard Deviation 𝒲rf = 1 – (1.3) = -0.30
Q 7.8% 10.5%
R 10.0 14.0 : 30% of the funds will be borrowed and 130% of the initial funds are invested in the
S 4.6 5.0 market portfolio. So we can conclude that this portfolio is a borrowing portfolio.
T 11.7 18.5
U 6.2 7.5 E(Rp) = Wm · E(Rm) + Wrf · E(Rf)
= 1.30 (10%) + (-0.30) (3%) = 12.1% .

CML equation method:

E(Rp) = 3% + (0.50) σp
= 3% + (0.50) (18.2%) = 12.1%.

: Both methods agree that the expected portfolio return is 12.1%.