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Investment Theory Body Kane Marcus
Investment Theory Body Kane Marcus
Investment Theory Body Kane Marcus
CHAPTER 6
a. The expected cash flow is: (0.5 x $70,000) + (0.5 x 200,000) = $135,000
With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is 14%.
Therefore, the present value of the portfolio is:
$135,000/1.14 = $118,421
b. If the portfolio is purchased for $118,421, and provides an expected cash inflow of $135,000,
then the expected rate of return [E(r)] is derived as follows:
$118,421 x [1 + E(r)] = $135,000
Therefore, E(r) = 14%. The portfolio price is set to equate the expected rate or return with
the required rate of return.
c. If the risk premium over T-bills is now 12%, then the required return is:
6% + 12% = 18%
The present value of the portfolio is now:
$135,000/1.18 = $114,407
d. For a given expected cash flow, portfolios that command greater risk premium must sell at
lower prices. The extra discount from expected value is a penalty for risk.
(5)
When we specify utility by U = E(r) .005A2, the utility from bills is 7%, while that from the
risky portfolio is U = 12 .005A x 182 = 12 1.62A. For the portfolio to be preferred to bills,
the following inequality must hold: 12 1.62A > 7, or,
A < 5/1.62 = 3.09. A must be less than 3.09 for the risky portfolio to be preferred to bills.
(6)
0%
5
10
15
20
25
2
0
25
100
225
400
625
E(r)
5.0%
5.375
6.5
8.375
11.0
14.375
The indifference curve is depicted by the bold line in the following graph (labeled Q3).
E(r)
U(Q4,A=4)
U(Q3,A=3)
U(Q5,A=0)
U(Q6,A<0)
(10)
Wbills x
Return
on bills +
Exp. return
Wmarket x on market
Portfolio
expected
return
Portfolio
standard deviation
_______________________________________________________________(=wmarketx16.2%)___
0.0
.2
.4
.6
.8
1.0
5%
5
5
5
5
5
1.0
.8
.6
.4
.2
0.0
8.66%
8.66
8.66
8.66
8.66
8.66
8.66%
7.93
7.20
6.46
5.73
5.00
16.5%
13.2
9.9
6.6
3.3
0
(11)
Computing the utility from U = E(r) .005 x A2 = E(r) .0152 (because A = 3), we arrive at
the following table.
Wbills
Wmarket
E(r)
2
U(A=3)
U(A=5)
___________________________________________________________________
0.
.2
.4
.6
.8
1.0
1.0
.8
.6
.4
.2
0
8.66%
7.93
7.20
6.46
5.73
5.0
16.5
13.2
9.9
6.6
3.3
0
271.92
174.03
97.89
43.51
10.88
0
4.58
5.32
5.73
5.81
5.57
5.0
1.86
3.58
4.75
5.38
5.46
5.0
The utility column implies that investors with A = 3 will prefer a position of 40% in the
market and 60% in bills over any of the other positions in the table.
(13)
(14)
Investment proportions:
.7 27% =
.7 33% =
.7 40% =
(15)
30.0%
18.9%
23.1%
28.0%
in T-bills
in stock A
in stock B
in stock C
18 8
28 = .3571
15 8
Client's reward-to-variability ratio = 19.6 = .3571
Your reward-to-variability ratio
30
25
CA L (Slope = .3571)
20
E( r)
15
%
Client
10
5
0
0
10
20
30
40
Problem 16
(19) a.
y* =
E(rP) - rf
18 - 8
10
=
=
2
27.44 = .3644
.01 3.5 282
.01 AsP
So the client's optimal proportions are 36.44% in the risky portfolio and 63.56% in T-bills.
b.
EXTRA PROBLEM
1. XYZ wish to combine two stocks: Brac and Delta, into a portfolio with an expected return of 16%.
The expected return of Brac is 2% and the standard deviation of 1%. The expected return of Delta is 25%
with a standard deviation of 10%. The correlation between the two stocks is 0.40.
A. What is the composition (weights) of the portfolio?
B. What is the portfolio standard deviation?
Solution:
A. What is the composition (weights) of the portfolio?
Set w = weight in Brac
16% w * 2% (1 w) * 25%
16% 25%
w
2% 25%
39.1304%
B. What is the portfolio standard deviation?
0.00391097
P 0.062538
6.2538%
2. An investor can design a risky portfolio with two stocks, A and B. Stock A has an expected
return of 18% and a standard deviation of 22.5%. Stock B has an expected return of 15% and a standard
deviation of 15%. The correlation coefficient between the two stocks is 0.75 and the risk-free T-bill rate is
9%.
(a) what are the weights of stocks A and B in the optimal risky portfolio (P)?
wA
[E(rA ) rf ] B2 [ E(rB ) rf ] A B AB
[ E(rA ) rf ] B2 [ E(rB ) rf ] A2 [ E(rA ) rf E(rB ) rf ] A B AB
3. Assume the T-Bill rate is 10% and the expected return on the market portfolio is 18%. An
investment is twice as risky as the market portfolio, in terms of its systematic risk. What is the
opportunity cost of capital (OCC) for this investment?
Based on CAPM:
r= rf + [E (Rm) rf]