Investment Science

Chapter 6
Solutions to Suggested Problems
Dr. James A. Tzitzouris
<jimt2@ams.jhu.edu>

6.1

The money invested is X0 . The money received at the end of a year is X0 − X1 + X0 . Hence,
2X0 − X1
R = .
X0

6.3

For solution method, see solution to Problem 6.4 in this solution set.

(a) α = 19/23

(b) The minimum standard deviation is approximately 13.7%.

(c) The expected return of this portfolio is approximately 11.4%.

6.4

Let α and β equal the percent of investment in stock 1 and stock 2, respectively. The problem is:

minα,β α2 σ12 + 2αβσ12 + β 2 σ22

s.t. α + β = 1.

1
Setting up the Lagrangian, L, we have:

L = α2 σ12 + 2αβσ12 + β 2 σ22 − λ(α + β − 1).

The first order necessary conditions are:

∂L
0= = 2ασ12 + 2βσ12 − λ,
∂α
∂L
0= = 2βσ22 + 2ασ12 − λ,
∂β
1 = α + β,

which imply

σ22 − σ12
α = .
σ12 + σ22 − 2σ12

The mean rate of return is simply αm1 + βm2 .

6.5

(a) The expected rate of return equals

(0.5)(3)(106 ) + (0.5)u
.
106 + 0.5u

(b) By inspection, it can be seen that buying 3 million units of insurance eliminates all uncertainty
regarding the return. So, 3 million units of insurance results in a variance of 0 and a corresponding
expected rate of return equal to
3
− 1 = 20%.
2.5

6.6

(a) The three assets are on a single horizontal line. The efficient set is a single point on the same
line, but to the left of the left-most of the three original points.

2
(b) Let wi be the percentage of the total investment invested in asset i. The since the assets are
uncorrelated, we have
Xn
var(total investment) = wi2 σi2 ,
i=1
where the weights sum to 1. Setting up the Lagrangian, we have
n n
!
X X
2 2
L = wi σi − λ wi − 1 ,
i=1 i=1

so that the first-order necessary conditions imply

λ
wi σi2 = , ∀i = 1, . . . , n,
2
λ
or wj = 2σj2
. Since the weights sum to 1, we have

2
λ = Pn 1 ,
i=1 σi2

which implies
σ̄ 2
wj = , ∀j = 1, . . . , n,
σj2

where
1
σ̄ 2 = Pn 1 .
i=1 σi2

The minimum variance is

n
X
2
σmin = wi2 σi2 = σ̄ 2 .
i=1

6.7

(a) First solve for the vi ’s from

2v1 + v2 = 1,
v1 + 2v2 + v3 = 1,
+ v2 + v3 = 1.

3
This yields v1 = 0.5, v2 = 0, and v3 = 0.5. This solution happens to be normalized, so also
w1 = 0.5, w2 = 0, and w3 = 0.5.

(b) In this case, we solve

2v1 + v2 = 0.4,
v1 + 2v2 + v3 = 0.8,
+ v2 + v3 = 0.8.
This yields v1 = 0.1, v2 = 0.2, and v3 = 0.3. This solution must be normalized, to arrive at
w1 = 1/3, w2 = 1/6, and w3 = 1/2.

(c) We find the vi ’s by the formula vi = vib − rf via where the vib ’s and the via ’s are the solutions from
parts (b) and (a) above, respectively. Thus, v1 = 0, v2 = 0.2, and v3 = 0.2. This solution must be
normalized, to arrive at w1 = 0, w2 = 1/2, and w3 = 1/2.

6.8

(a)

var(r − rM ) = var(r) − 2cov(r, rM ) + var(rM ),

Xn n
X
2
= αi αj σij − 2 αi σiM + σM .
i,j=1 i=1

So, to minimize var(r − rM ) subject to

n
X
αi = 1,
i=1
set up the Lagrangian
n n n
!
X X X
2
L= αi αj σij − 2 αi σiM + σM +λ αi − 1 .
i,j=1 i=1 i=1

The first order necessary conditions imply

n
X
αj σij − 2σiM + λ = 0, ∀i = 1, . . . , n,
j=1
n
X
αi = 1.
i=1

4
(b) Similar to (a) with the added constraint that
n
X
αi ri = m.
i=1

So, the first order necessary conditions imply

n
X
αj σij − 2σiM + λ + µri = 0, ∀i = 1, . . . , n,
j=1
n
X
αi ri = m,
i=1
Xn
αi = 1.
i=1