BEA3008 Finance for Managers

Tutorial Assignment 3

Portfolio Theory

1. The table below shows the risk and return characteristics of two projects:

Asset 1 Asset 2
Expected return 0.20 0.10
Variance of returns 0.25 0.07

(a) Given a portfolio made up from proportionate investments

ω1 and
ω2 in
assets investments in assets 1 and 2, respectively, show that

σ 2p =0.25 ω12 +0.2646 ρ1,2 ω1 ω 2 +0.07ω22

where
σ 2p represents the portfolio’s variance of returns, and ρ1,2 represents
the correlation coefficient between the assets’ returns.

(b) Given that an investor allocates a proportion of 0.3460 of his funds to the first asset
and 0.6540 to the second asset

(i) Compute the expected return on his portfolio.

(ii) Complete the following table, and comment on the implications this has with
regards to diversification.

ρ1,2 σp
1.00 0.3460
0.75
0.50
0.25
0.00 0.2447
-0.25
-0.50
-0.75
-1.00

(c) What is covariance and why is it important in portfolio theory?

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2. Lancaster plc has been specially formed to undertake two investment opportunities. The risk
and return characteristics of the two projects are shown below.

A B
Expected return 12% 20%
SD of returns 3% 7%

Lancaster plc plans to invest 80% of its available funds in Project A and 20% in Project B. The
directors believe that the correlation coefficient between the returns of the projects is 0.1.

(a) Calculate the expected return and risk of the proposed portfolio of projects A and B.

(b) Comment on your calculations in part (a) in the context of the risk-reducing effects
of diversification.

(c) Suppose the correlation coefficient between A and B was -1, how should Lancaster
plc invest its funds in order to obtain a zero-risk portfolio?

3. There are three securities in the market. The following table shows their possible pay-offs.

Probability Return on Return on Return on

State
of Outcome security 1 security 2 security 3
1 0.10 0.25 0.25 0.10

2 0.40 0.20 0.15 0.15

3 0.40 0.15 0.20 0.20

4 0.10 0.10 0.10 0.25

(a) What are the expected return and standard deviation of each security?

(b) What are the covariances and correlations between the pairs of securities?

(c) What are the expected return and standard deviation of a portfolio with half of its
funds invested in:

(i) Security 1 and half in security 2?

(ii) Security 1 and half in security 3?
(iii) Security 2 and half in security 3?

(d) What do your answers in parts (c) imply about diversification?

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4. Distinguish between systematic and unsystematic risk and explain why is the standard
deviation of a portfolio usually smaller than the standard deviations of the assets that
comprise the portfolio.
5. Define the feasible (opportunity set) and explain how it differs from the MVE frontier.

6. Which portfolio on the efficient frontier is the “optimal” portfolio for a risk-averse investor?
Explain.