Exercise Sheet 4

Exercise 1
The table provides data on the return and standard deviation for dierent
compositions of a two-asset portfolio. Plot the data to obtain the portfolio
frontier. Where is the minimum variance portfolio located?
X

rp
p

0
.08
.5

.1
.076
.44

.2
.072
.38

.3
.068
.33

.4
.064
.29

.5
.060
.26

.6
.056
.24

.7
.052
.25

.8
.048
.27

.9
.044
.30

1
.04
.35

Solution 1
The plot is obtained by putting the data into Excel.
0.085

X =0

X = 0.2

0.075

X = 0.4

0.065
0.055

X = 0.8

0.045

X =1

0.035
0.2

0.3

0.4

0.5

The minimum variance portfolio is located around X = 0:6.

Exercise 2
Assuming that the returns are uncorrelated, plot the portfolio frontier without short sales when the two available assets have expected returns 2 and 5 and
variances 9 and 25.
Solution 2
The expected return and standard deviation are
r p = XA r A + XB r B ;

2
= XA

2
A

2
+ XB

2
B

+ 2XA XB

1=2
AB

Using the data in the exercise

rp = XA 2 + XB 5;

2
2
= XA
9 + XB
25 + 2XA XB 0

or
rp = XA 2 + [1

XA ] 5;

h
2
= XA
9 + [1

Computing these expressions gives the table below.

X

rp
p

0
5
5

.1
4.7
4.5

.2
4.4
4.0

.3
4.1
3.6

.4
3.8
3.2

.5
3.5
2.9

.6
3.2
2.7

.7
2.9
2.58

1=2

i1=2
2
XA ] 25
:
.8
2.6
2.6

.9
2.3
2.7

1
2.0
3

Dell
Year
98
99
0
1
2
3
4
5
6
7
8

Intel
Year

Nov Price Dividend Return

30.41
43
0 0.414009
19.25
0 -0.552326
27.93
0 0.450909
28.6
0 0.023989
34.57
0 0.208741
40.52
0 0.172115
30.15
0 -0.255923
27.24
0 -0.096517
24.54
0 -0.099119
12.77
0 -0.479625

98
99
0
1
2
3
4
5
6
7
8

Nov Price Dividend

24.37
34.79
0.02
34.58
0.08
29.75
0.08
19.09
0.08
30.77
0.08
20.66
0.16
24.96
0.32
20.43
0.4
25.39
0.44
15.06
0.55

Return
0.428396
-0.003737
-0.137363
-0.35563
0.616029
-0.323367
0.223621
-0.165465
0.264317
-0.385191

Mean Return

-0.021375

Mean Return

0.016161

Variance of Return

0.118185

Variance of Return

0.122883

cov(D,I)

0.030263

X =0
X = 0 .2

4.8
4.3
3.8
3.3
2.8
2.3
1.8

X = 0.4
X = 0.8
2

X =1
3

This data generates the plot.

Exercise 3
Using 10 years of data from Yahoo, construct the portfolio frontier without
short selling for Intel and Dell stock.
Solution 3
Analyzing the data from Yahoo gives the following results.
Plotting this data gives the portfolio frontier in the gure.
Exercise 4
Given the standard deviations of two assets, what is smallest value of the
correlation coe cient for which the portfolio frontier bends backward? (Hint:
assuming asset A has the lower return, nd the gradient of the frontier at
XA = 1.)
Solution 4
2

_
rp
0.02
Dell = 0, Intel = 1

0.015
0.01
0.005

0
-0.0050.25

0.27

0.29

0.31

0.33

0.35

0.37

-0.01
-0.015
-0.02

Dell = 1, Intel = 0

-0.025

The frontier is described by

rp = XA rA +[1

XA ] r B ;

h
2
= XA

2
A

+ [1

2
B

XA ]

+ 2XA [1

XA ]

A B AB

The gradient of the frontier is dened by

i1=2

drp
drp =dXA
=
:
d p
d p =dXA
It is vertical when d
d p
1
= [
dXA
2

p]

1=2

p =dXA

2XA

2
A

= 0. Calculating this derivative

2 [1

2
B

XA ]

+ 2 [1

XA ]

A B AB

2XA

A B AB

Evaluating this at XA = 1 and setting equal to 0

1
[
2

p]

1=2

2
A

A B AB

= 0:

Hence the e cient frontier is vertical at XA = 1 when

AB

Since A > 0 and B > 0 the minimum value of AB is positive. For any value
A
less than B
the e cient frontier will bend backward.
Exercise 5
3

Allowing short selling, show that the minimum variance portfolios for AB =
+1 and AB = 1 have a standard deviation of zero. For the case of a zero
correlation coe cient, show that it must have a strictly positive variance.
Solution 5
The portfolio variance is
2
p

2
= XA

2
A

+ [1

XA ]

2
B

+ 2XA [1

XA ]

AB A B

With perfect positive correlation,

2
B

XA =

2
A

A B
2
B

A B

;
A

Hence
2
2
p

=
B

2
2
A

+ 1
B

2
B

+2
B

1
A

A B
B

0:

With perfect negative correlation

2
B

XA =

2
A

+
2
B

A B

+2

A B

:
B

Hence
2
2
p

=
=

A+

2
2
A

+ 1

A+

2
B

A+

1
B

B
A+

0:

When the assets are uncorrelated

XA =

2
B

2 :
B

2
A

2
A

+ 1

Hence
2
p

2
B

2 +
A
2 2
A B
2
A

2
B

2
B
2
A

2
B

2
B

2
B

> 0:
Exercise 6
Using the data in Exercise 2, extend the portfolio frontier to incorporate
short selling.
Solution 6
4

A B
B

Using Excel the returns and standard deviations can be computed. This is
shown in the table where the left-hand column is the proportion of asset A, the
central column the expected return and the nal column the standard deviation.
-0.5
-0.4
-0.3
-0.2
-0.1
0
0.1
0.2
0.3
0.4
0.5
0.6
0.7
0.8
0.9
1.0
1.1
1.2
1.3
1.4
1.5

6.5
6.2
5.9
5.6
5.3
5
4.7
4.4
4.1
3.8
3.5
3.2
2.9
2.6
2.3
2
1.7
1.4
1.1
0.8
0.5

7.64852927
7.102112362
6.562011887
6.029925373
5.508175742
5
4.509988914
4.044749683
3.6138622
3.231098884
2.915475947
2.690724809
2.58069758
2.6
2.745906044
3
3.337663854
4.178516483
4.65188134
4.65188134
5.14781507

The frontier is plotted in the gure.

7
6
5
4
3
2
1
0

X =0

X =1

Exercise 7
Calculate the minimum variance portfolio for the data in Example 43. Which
asset will never be sold short by an e cient investor?
EXAMPLE: Let asset A have expected return rA = 2 and standard
deviation A = 2 and asset B have expected return rB = 8 and
standard deviation B = 6: Table 4.3 gives the expected return
5

and standard deviation for various portfolios of the two assets when
1
AB =
2:
Solution 7
In Example 43 asset A has expected return rA = 2 and standard deviation
A = 2, and asset B has expected return rB = 8 and standard deviation B = 6:
The correlation coe cient is AB = 21 :
The proportion of asset A in the minimum variance portfolio is given by
XA

2
B

A B AB

2
A

+ 2B 2 A B AB
36 2 6 ( 0:5)
=
4 + 36 2 2 6 ( 0:5)
= 0:80769;

so
XB = 0:19231:
Exercise 8
h
i
r r
For a two-asset portfolio, use (rP = rf + p p f P ) to express the risk
and return in terms of the portfolio proportions. Assuming that the assets have
expected returns of 4 and 7, variances of 9 and 25 and a covariance of 12;
graph the gradient of the riskreturn trade-o as a function of the proportion
held of the asset with lower return. Hence identify the tangency portfolio and
the e cient frontier.
Solution 8
The riskreturn tradeo is always given by
r = rf +

rp

rf

where is a portfolio of the risk free asset and a risky portfolio. The gradient
r
r
is p p f which can be evaluated using the data in the exercise as
rp

rf

XA rA + [1

2
XA

2 9 + [1
XA

XA ] 25

rf

2
A

+ [1

2
B

XA ]

XA 4 + [1

2
[58XA

3XA

XA ] r B
+ 2XA [1

XA ] 7

1=2

2XA [1
:

rf
XA ]

AB

XA ] 12

i1=2

rf

i1=2

74XA + 25]

Assume that rf = 1. The gradient can be plotted as below. This shows that
if rf = 1 the tangency portfolio is XA = 0:6202 and XB = 0:3798:
6

rp r f

0.6202

Exercise 9
Taking the result in Example 61, show the eect on the tangency portfolio
of (a) an increase in the return on the risk-free asset and (b) an increase in the
riskiness of asset A. Explain your ndings.
Solution 9
Assume that rf = 2. The gradient can be plotted as below.So if rf = 2 the
tangency portfolio is XA = 0:6145 and XB = 0:3855: Comparing with rf = 1
the tangency portfolio has less of asset A and more of asset B.
The example shows that the proportion of asset A in the tangency portfolio
is given by
2
rf ]
B [rA
XA = 2
:
2 [r
[r
r
]
+
rf ]
f
A B
B A
(a) As rf goes up, XA goes down.
(b) As A goes up, XA goes down.
Exercise 10
What is the outcome if a risk-free asset is combined with (a) two assets whose
returns are perfectly negatively correlated and (b) two assets whose returns are
perfectly positively correlated?
Solution 10
(a) There is an arbitrage opportunity unless the minimum variance portfolio
has the same return as the risk free asset.
7

rp r f

0.6145

rp

Either
leads to
arbitrage

rf

rmvp
rf

rp

Either
leads to
arbitrage

rf

rmvp
rf

(b) There is also an arbitrage opportunity unless the risk free asset has the
same return as the minimum variance portfolio.