Tutorial 6: Chap 7 Efficient Diversification

1. Which of the following factors reflect pure market risk for a given corporation
a. Increased short-term interest rates (systematic risk, cannot control)
b. Fire in the corporate warehouse (non-systematic risk, only certain industry)
c. Increased insurance costs (non-systematic risk, insurance charged based on capital
loss, if consider lower risk, charged lower)
d. Death of the CEO (non-systematic risk)
e. Increase labor cost (systematic risk)
(a) and (e). Short-term rates and labour issues are factors that are common to all firms
and therefore must be considered as market risk factors. The remaining three factors are
unique to this corporation and are not a part of market risk.
2. When adding real estate to an assets allocation program that currently includes only
stocks, bonds, and cash, which of the properties of real estate returns most affects
portfolio risk? Explain. (portfolio variance= w2σ2 + w2σ2 + 2wswb ρsbσsσb)
a. Standard deviation
b. Expected return
c. Correlation with returns of the other asset classes
(a) and (c). After real estate is added to the portfolio, there are four asset classes in the
portfolio: stocks, bonds, cash and real estate. Portfolio variance now includes a variance
term for real estate returns and a covariance term for real estate returns with returns for
each of the other three asset classes. Therefore, portfolio risk is affected by the variance
or standard deviation of real estate returns and the correlation between real estate returns
and returns for each of the other asset classes. (Note that the correlation between real
estate returns and returns for cash is most likely zero.)
3. Which of the following statement about the minimum-variance portfolio of all risky
securities is valid? (Assume short sales are allowed) Explain.
Minimum-varaince means lower standard deviation
a. Its variance must be lower than those of all other securities or portfolios.
b. Its expected return can be lower than the risk-free rate. (default risk is associated
with)
c. It may be the optimal risky portfolio.
d. It must include all individual securities.
The statement “Its variance must be lower than those of all other securities or portfolios”,
about the minimum variance portfolio of all risky securities is valid because the standard
deviation of the minimum variance portfolio is smaller than that of the standard deviation
of either of the individual assets, which illustrates the effect of diversification.
The following data apply to Problem 4 through 10: A pension fund manager is
considering three mutual funds. The first is a stock fund, the second is a long-term bond
fund, and the third is a money market fund (always represents risk-free assets) that provides a
safe return of 8%. The characteristics of the risky funds are as follows:

Expected Standard Deviation

Return
Stock fund (S) 20% 30%
Bond fund (B) 12% 15%
The correlation between the fund return is 0.10
4. What are the investment proportions in the minimum-variance portfolio of the two risky
funds, and what are the expected value and standard deviation of its rate of return?
Covariance matrix
Stock Bond
Stock 302 = 900 30*15*0.1
(s) =45
Bond 30*15*0.1 152=225
=45
Wmin(s) = (σb²-ρsbσsσb) / (σs² + σb² – 2ρsbσsσb)
= (225-45)/(900+225-(2*45))
= 0.1739

Wmin(s) = (σb²-ρsbσsσb) / (σs² + σb² – 2ρsbσsσb)

= (0.152-0.1*0.30*0.15)/ (0.302+0.152-2*0.1*0.3*0.15)
= 0.018/0.1035
= 0.1739/17.39%

Wmin(b)= 1-0.1739
= 0.8261/82.61%
Expected return= WsE(rs) + WbE(rb)
= (0.1739*0.2) + (0.8261*0.12)
= 0.1339/ 13.39%
Variance= w σ + w2σ2 + 2wswb ρsbσsσb
2 2

= (0.17392*302) + (0.82612*152) + 2*0.1739*0.8261*45

= 193.6956
Standard deviation = 0.1392/13.92%
portfolio variance= we2σe2 + wd2σd2 + 2wewd ρedσeσe
portfolio variance= we2σe2 + (1-we2)σd2 + 2wewd ρedσeσe
insert formula

9. You are require that your portfolio yield an expected return of 14%, and that it be
efficient, that is, on the steepest feasible CAL
a. What is the standard deviation of your portfolio
 E(r) overall= 0.14
E(rC) = rf +{[E(rP)-rf]/σP}σC
0.14 = 0.08+[(0.1339-0.08)/0.1496] σC
0.06 = 0.3603 σC
σC= 0.1665/16.65%

b. What is the proportion invested in the money market fund and each of the two risky
fund?
Optimal risky portfolio

10. If you were to use only the two risky funds and still require an expected return of 14%,
what would be the investment proportions of your portfolio? Compare its standard
deviation to that of the optimized portfolio in Problem 9. What do you conclude?
E(rp)=WsE(rs) + WbE(rb)
0.14= 0.2ws+0.12(1-ws)
0.14=0.2ws+0.12-0.12ws
0.02=0.08ws
Weight of stock = 0.25
Weight of bond = 1-0.25=0.75
Variance= w12sd12+w22sd22+2w1w2Cov(sd1,sd2)
= 0.252 (900)+0.752(225)+2(0.25)(0.75)(45)
= 199.6875
SD= 14.13%

12. Suppose that there are many stocks in the security market and that the characteristics of
stocks A and B are given as follows:
Stoc Expected Standard
k return Deviation
A 10% 5%
B 15 10
Suppose that it is possible to borrow at the risk-free rate rf. What must be the value of the
risk-free rate? (Hint: Think about constructing a risk-free portfolio from stocks A and B)
When correlation= -1
Wa=SDb/(SDb+SDa)
= 10/(10+5)
= 0.6667
Wb= 1-0.6667=0.3333
E(r)= (0.6667*0.1)+(0.3333*0.15)
= 0.11667/11.667%

Variance= w12sd12+w22sd22+2w1w2Cov(sd1,sd2)
Variance= w12sd12+w22sd22+2w1w2sd1sd2
0= w1252+(1-w1)102+2w1(1-w1)*5*10