Principles of Finance

HEC Lausanne Homework 4 November 3, 2019

Problem 1
Assume that there are two risky assets listed in the market. Expected returns and risks for
the risky assets are

E[R] σ
7.5% 22%
10% 27%

a) Determine the analytical formulation of the expected return of a portfolio as a function

of the standard deviation of the portfolio in case the two risky assets are perfectly positively
correlated.
b) Determine the analytical formulation of the expected return of a portfolio as a function
of the standard deviation of the portfolio in case the two risky assets are perfectly negatively
correlated.

Problem 2
In a financial market there are two risky assets A and B and a risk-free security. The returns
over the next year of the risky assets are uncorrelated and the expected returns and variances
are µA = 0.03, µB = 0.12, σA = 0.09 and σB = 0.18. A portfolio manager is holding the
following portfolio:

risk-free Asset A Asset B

Manager 1500 $ 4313 $ 3187 $

a) Find out the composition, the expected return and risk of the tangency portfolio.

b) The manager allocation optimizes a mean-variance utility function, E(rp ) − 21 γσp2 with
γ = 7, find the return r0 of the risk-free asset.

c) Find the composition of the minimum variance portfolio with an expected return equal
to 4%. Is this portfolio efficient?

Problem 3
Assume that only two risky assets are traded in the market and that they have the following
expected returns, risks and correlation

1
 Principles of Finance
HEC Lausanne Homework 4 November 3, 2019

A B
µ 0.04 0.10
σ 0.10 0.15
ρ 0.3

a) Calculate the composition of the absolute minimum variance portfolio and plot the mean
variance efficient frontier. Which condition (in terms of ρAB , σA and σB ) must be satisfied
in order for this portfolio not to be fully invested in security A?

Problem 4
Two risky assets a and b are listed in the market. A rational investor with a mean variance
utility function E[U ] = µp − 12 γσp2 with γ = 2 has the following expectations:

a b
µ 0.05 0.10
σ 0.10 0.20

a) If we know that this investor is holding a portfolio with the following composition wa =
0.28261 and wb = 0.71739, can we infer the expectation of this investor about the corre-
lation level ρab between two assets?

b) A risk-free asset with a return r0 = 2.5% becomes available in the economy and we observe
a second rational mean variance investor, more risk averse (γ2 = 5) than the first one,
is holding the following portfolio wa = 0.429299, wb = 0.353540, and w0 = 0.217161.
Assuming that the two investors share the same expectations about the future behavior
of the risky assets, can we predict how the first investor will modify her portfolio in order
to incorporate the newly-available risk-free asset?