Tutorial 1

Portfolio Optimization-ECO 4122Z

March 14, 2018

1. Suppose on 28 February 2017, you bought 100 shares of stock in African Equity Em-
powerment Investments Limited for R3.95 per share and you sold them on 28 February
2018 for R7.20 per share. During this period, you received a total cash dividend of

m
R0.108 a share. Compute your HPR and HPY on this African Equity Empowerment

er as
Investments Limited stock.

co
eH w
[2 marks]

o.
Sugested Solution rs e
ou urc
EndingV alue 7.20+0.108−3.95
HP R = BeginningV alue
= 3.95
= 0.8501

HP Y = HP R − 1 = 0.8501 − 1 = 0.1498 or 14.98%

o
aC s

2. Two securities have the following joint distribution of returns, r1 and r2 :

vi y re

P [r1 = −1.0 and r2 = 0.15] = 0.1

P [r1 = 0.5 and r2 = 0.15] = 0.8,
P [r1 = 0.5 and r2 = 1.65] = 0.1
ed d
ar stu

a. Compute the means, variances and covariance of the returns for the two securities
is

[1; 2; 2 marks]
b. Plot the feasible mean-standard deviation (E(R), σ) combinations, assuming that
Th

the two securities are the only investments available.

[5 marks]
sh

c. Identify the portfolios that belong to the efficient set

[2 marks]
d. Show that security 2 is mean-variance dominated by security 1, yet enters all
efficient portfolios but one. How do you explain this?
[3 marks]

1
This study source was downloaded by 100000805188850 from CourseHero.com on 05-10-2021 11:10:11 GMT -05:00

https://www.coursehero.com/file/29707574/Tutorial-1-solpdf/
 c. Suppose the possibility of lending, but not borrowing, at 5% (without risk) is
added to the previous opportunities. Draw the new set of (E(R), σ) combinations.
Which portfolios are now efficient?
[2;1 marks]

Sugested Solution

a. E(r1 ) = 0.1 ∗ (−1.0) + 0.8 ∗ (0.5) + 0.1 ∗ (0.5) = 0.35,

E(r2 ) = 0.1 ∗ (0.15) + 0.8 ∗ (0.15) + 0.1 ∗ (1.65) = 0.30
V ar(r1 ) = 0.1(−1 − 0.35)2 + 0.8 ∗ (0.5 − 0.35)2 + 0.1(0.5 − 0.35)2 = 0.2025
V ar(r2 ) = 0.1(0.15 − 0.30)2 + 0.8 ∗ (0.15 − 0.30)2 + 0.1(1.65 − 0.30)2 = 0.2025
Cov(r1 , r2 ) = 0.1(−1 − 0.35)(0.15 − 0.30) + 0.8 ∗ (0.15 − 0.30)(0.5 − 0.35) + 0.1(1.65 −
0.30)(05 − 0.35) = 0.0225

m
er as
Computations for the Opportunity Set

co
eH w
% in 1 % in 2 E(Rp ) σp2 σp
100 0 .3500 .2025 .450

o.
75 25 .3375 .1350 .367
rs e 50 50 .3250 .1125 .335
ou urc
25 75 .3125 .1350 .367
0 100 .3000 .2025 .450
o

Minimum variance portfolio

aC s

σ 2 −σ12
ω ∗ = σ2 +σ2 2 −2σ
vi y re

1 2 12

0.2025−.0225
= 0.2025+0.2025−2(0.0225)
ed d

=0.5
ar stu
is
Th
sh

2
This study source was downloaded by 100000805188850 from CourseHero.com on 05-10-2021 11:10:11 GMT -05:00

https://www.coursehero.com/file/29707574/Tutorial-1-solpdf/
 c. Efficient set starts from solid line above, i.e starts from the minimum variance portfolio

d. This is due to diversification benefits it offers since it is not perfectly correlated with 1.

e. With riskfree lending, the graph will be as shown below

m
er as
co
eH w
3. Given the exponential utility function U (W ) = −e−αW

o.
a. Graph the function, assuming α < 0
rs e
ou urc
[2 marks]
b. Does the function exhibit positive marginal utility and risk aversion?
o

[2 marks]
aC s
vi y re

c. Assess whether the function has a decreasing, increasing or constant

i. Absolute risk aversion
ii. Relative risk aversion
ed d

[2 marks]
ar stu

Suggested Solution
is
Th
sh

3
This study source was downloaded by 100000805188850 from CourseHero.com on 05-10-2021 11:10:11 GMT -05:00

https://www.coursehero.com/file/29707574/Tutorial-1-solpdf/
 m
er as
co
Note: This questions tests your understanding of the nature of the graph not the figures

eH w
o.
b. U 0 (W ) = −(−α)e−αW . there is positive marginal utility. The investor risk aversion is
rs e
positive regardless of the level of wealth.
ou urc
2 αW
c. ARA = − −α e
αe−αW
= α. There is constant absolute risk aversion

d. W RA = αW . Relative risk aversion increases with wealth

o
aC s

4. State whether the following are true or false.

vi y re

a. If asset X is stochastically dominant over asset Y according to the second-order

criterion, it is also dominant to the first-order criterion. False. Using SOSD, X
dominates Y , because they have the same mean, but X has lower variance. How-
ed d

ever there is no FOSD since they have the same mean, therefore the cumulative
ar stu

density functions (CDFs) will cross

b. If asset X has a higher mean and higher variance than asset Y , it is stochastically
dominant, according to the first-order criterion. False.There is no SOSD in this
is

case. the CDFs will cross therefore no FOSD

Th

c. A risk-neutral investor will use second-order stochastic dominance as a decision

criterion only if the return of the underlying assets are normally distributed.False.Risk
neutral investor has a linear utility function- he/she will always choose highest
expected return (mean)
sh

d. A second-order stochastic dominance is consistent with utility functions that have

positive marginal utility and risk aversion . True.Utility functions with positive
marginal utility and risk aversion are concave. SOSD is equivalent to maximizing
expected utility for risk averse investors
[4 marks]

4
This study source was downloaded by 100000805188850 from CourseHero.com on 05-10-2021 11:10:11 GMT -05:00

https://www.coursehero.com/file/29707574/Tutorial-1-solpdf/
 [Total 30 marks]

m
er as
co
eH w
o.
rs e
ou urc
o
aC s
vi y re
ed d
ar stu
is
Th
sh

5
This study source was downloaded by 100000805188850 from CourseHero.com on 05-10-2021 11:10:11 GMT -05:00

https://www.coursehero.com/file/29707574/Tutorial-1-solpdf/
Powered by TCPDF (www.tcpdf.org)