Question 6

A project has a 0.7 chance of doubling your investment in a year

and a 0.3 chance of halving your investment in a year. What is the
standard deviation of the rate of return on this investment?

Answer

The probability distribution is as follow:

Probability Rate of Return

0.7 100%
0.3 -50%

The mean = (0.7 x 100) + (0.3 x (-50)) = 55%

Variance = 0.7 (100 – 55)2 + 0.3 (-50 – 55)2 = 4725

Standard deviation = 47251/2 = 68.74%

Question 7

Investors expect the market rate of return this year to be 10%. The
expected rate of return on a stock with a beta of 1.2 is currently
12%. If the market return this year turns out to be 8%, how would
you revise your expectation of the rate of return on the stock?

[Hint: Use the CAPM equation you learnt in basic finance (FI3300):
E(R) = Rf + β [E(Rm) – Rf], E(R) is expected return, Rf is riskfree rate,
Rm is the market-return]

Answer

The expected return on the stock will change by beta times the
unanticipated chance in the market return: 1.2 (8 – 10) = -2.4%
Therefore the expected rate of return would be revised to: 12 – 2.4
=9.6%
Question 8

A pension fund manager is considering three mutual funds. The first is a

stock fund, the second is a long-term government and
corporate bond fund, and the third is a T-bill money market fund
that yields a sure rate of 5.5%. The probability distributions of the

risky funds are:

Expected Return Standard Deviation
Stock fund (S) 15% 32%
Bond fund (B) 9% 23%
The correlation between the fund returns is 0.15.

What is the Sharpe ratio of the best feasible CAL?

Answer

Let’s first find the optimal portfolio weight for the two risky funds.

wB= [E(rB) − rf] σ2 S − [E(rS) − rf]σBσSρBS./ [E(rB) − rf]σ2S + [E(rS) − rf]σ2B −

[E(rB) − rf + E(rS) − rf]σBσSρBS
ws = 1 - wB

wB = 2535.2/7174.3
wB = 0.35
wS = 1 - 0.35
wS = 0.65

Then the expected return of the optimal portfolio will be :

E(rO) = wB x E(rB) + wS x E(rS)

E(rO) = 0.35 x 15 + 0.65 x 9
E(rO) = 5.25 + 5.85
E(rO) = 11.1 %

The Standard deviation of the rate of return of the two risky-funds is:
σ2P= (wBσB)2 + (wSσS)2 + 2(wBσB)(wSσS)ρBS
σ2P = (0.35 x 23)2 + (0.65 x 32)2 + 2(0.35 x 23)(0.65 x 32)0.15
= 64.8 + 432.64 + 50.232
= 547.67
σP = 23.40 %

The Sharp ratio of the best feasible CAL is:

So = E(ro) – rf / σo
So = 11.1 – 5.5/ 23.40
So = 0.24