THE INSTITUTE OF FINANCE MANAGEMENT

FACULTY OF ACCOUNTING, BANKING AND FINANCE

DEPARTMENT OF ACCOUNTING AND FINANCE

DODOMA TEACHING CENTER

MASTER OF SCIENCE IN FINANCE AND INVESTMENT

AF 09202: ADVANCED PORTFOLIO MANAGEMENT

ACADEMIC YEAR 2018/2019

DATE: MONDAY 9TH SEPTEMBER, 2019 TIME ALLOWED: 3 HOURS

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GENERAL INSTRUCTIONS:

1. There are Four (4) questions in this paper, attempt ALL the Four questions.
2. Marks are allocated for each question, plan your time wisely.
3. All answers should be written in the answer sheets provided.
4. You are reminded to adhere to all Institute’s examination regulations

1
QUESTION ONE

a. Write short notes on the following;

i. Markowitz portfolio theory (3 Marks)

Answer; Markowitz portfolio theory is the theory which provides

theoretical framework for analysis of risk and return and their inter-
relationships for selection of assets in a portfolio in efficient manner.
This theory leads to the idea of efficient portfolio.
This theory is based on the following key assumptions;
a. Investors are rational and behave in a manner to maximize
their utility with a given level of income.
b. Investors have free access to correct information on the
return and risk
c. Markets are efficient
d. Investors are risk averse
e. Investors choose higher return to lower return for given level
of risk.
ii. Unsystematic risk (3 Marks)

Answer; Unsystematic risk is the risk that is peculiar to one company or industry. This
type of risk can be eliminated by diversification. This risk stems from the fact that many
of the perils that surround an individual company are peculiar to that company and perhaps
its immediate competitors.

Examples;

a. Poor management quality,

b. Labour problems
c. Political risks
d. Technological changes
e. A formidable competitor enters the market
f. A company loses a big contract in a bid

iii. Optimal portfolio (3 Marks)

Answer; Optimal Portfolio is the one which allow investor to get onto the
highest indifference curve
Graphically is a point where indifference curve is tangent to the efficient
frontier
Any two investors are likely to have different utility functions, thus, their
optimal portfolios are likely to differ

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 iv. Non-satiation theory (3 Marks)

Answer; This theory assert that in investment selection higher return is preferred
to lower return in forming an efficient portfolio. They key assumption is that
consumer will always benefit from additional consumption.

b. Assume that the average variance of return for an individual security is 50 and that the
average covariance is 10. What is the expected variance of an equally weighted portfolio
of 5, and 10 securities? (6.5 Marks)
Solution;
1  1
VAR(RP ) = AV .VAR + 1 −  AV .COV
N  N
(2.5 marks)
Expected variance of an equally weighted portfolio of 5 securities

VAR(Rp)=1/5*50 + (1 -1/5)*10=18 (2 Marks)

Expected variance of an equally weighted portfolio of 10 securities

VAR(Rp)=1/10*50 + (1 -1/10)*10=14 (2 Marks)

c. The returns on securities A and B are perfectly negatively correlated. The standard
deviations on these securities are 25 and 15 percent respectively. How much needs to be
invested in A to eliminate risk entirely? (6.5 Marks)

Solution

W A = SD( R B ) / [SD( R A ) + SD( R B ))] (2 marks

WA=15/(25+15) =37.5% (3 marks)

37.5% of the wealth needs to be invested in security A to eliminate the entire portfolio risk.
(1.5 marks)

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QUESTION TWO

a. Briefly explain the following terms;

i. Minimum portfolio variance (3 Marks)
Answer; This is obtained by altering the proposition of wealth invested in
securities to attain efficient portfolio with minimum risk. This is attained
by differentiating Variance of portfolio with respect to weight. Table
below depicts minimum portfolio variance. Point X on the efficient
frontier indicates minimum portfolio variance.

IDENTIFYING THE MINIMUM PORTFOLIO VARIANCE

Expected
Return
B

Risk [SD(R)]
The minimum portfolio variance is given by point X on the risk-
return line for portfolios A and B.

ii. Correlation coefficient (3 Marks)

Answer; The correlation coefficient is a measure of the tendency for two variables
to move together on a scale of +1.0 to -1.0. To consider the interdependence of
returns further let us consider four possibilities:

• perfect positive correlation;

• perfect negative correlation;
• zero correlation; and
• imperfect positive correlation.

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iii. Naïve diversification (3 Marks)

Answer; This refers to the process of constructing portfolio by selecting randomly

assets or securities to be included in the portfolio without guidance of any analysis.
This concept has empirically researched and it proved the basis that there is an
inverse relationship between the increase in securities or assets in the investor’s
portfolio and total risks of the portfolio. That is an increase in number of securities
decreases the risk of a portfolio in a decreasing rate until a given level whereby any
further additional of securities will have no significant impact on the total risk.

RISK REDUCTION THROUGH RANDOMLY CONSTRUCTED

PORTFOLIOS
Portf
olio
Risk
(SD)

Diversifiable
Risk

Non Diversifiable Risk

0 5 10 15 20 Number of Securities in the
Portfolio

iv. Diminishing Marginal Utility (3 Marks)

Diminishing marginal utility of wealth implies that the loss of utility resulting
from a given reduction in wealth is greater than the gain of utility which
would follow from an increase of wealth of equal magnitude.

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b. Given the following information for security X, Y and Z
X Y Z
Expected Return 23% 18% 27%
Standard Deviation of Return 12% 15% 16

Variance-covariance Matrix
X Y Z
X 144 162 115.2
Y 162 225 72
Z 115.2 72 256
Required;
i. Compute the expected return and risk of portfolio if the securities X, Y
and Z are equally invested (7 Marks)

Solution

Expected return

E ( R p ) = W A E ( R A ) + WB E ( RB ) +WcE(Rc)

(1 marks)

E(Rp)=1/3*+1/3*18+1/3*27=22.67%

Therefore the expected return of equally invested security X,Y and Z is 22.67%

(2 marks)

Risk of portfolio

VAR( R p ) = W 12 VAR( R1 ) + W 22 VAR( R 2 ) + W 23 VAR ( R 3 )

+ 2 W 1 W 2 COV ( R1 R 2 )

+ 2 W 1 W 3 COV ( R1 R 3 )

+ 2 W 2 W 3 COV ( R 2 R 3 )

(1 Marks)

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 VAR(Rp)=(1/3)*(1/3)*144+) + (1/3)*(1/3)*225 + (1/3)*(1/3)*256 +

2*(1/3)*(1/3)*162 +2*(1/3)*(1/3)*115.2 + 2*(1/3)*(1/3)*72=146.85

=12.11%

Therefore the risk of the portfolio is 12.11% (3) marks

ii. Compute the expected return and risk of portfolio comprised of 30%
invested in security Y and 70% invested in security Z. (6 Marks)

Solution
Expected return

E ( R p ) = W A E ( R A ) + WB E ( RB ) (1 marks)

E(Rp)=0.3*18+0.7*27
=24.3%
The expected return of portfolio is 24.3%
Risk of portfolio
VAR( R p ) = [SD( R p ) ] 2 = [ W A SD( R A ) + W B (SD( R B )) ] 2

VAR( R P ) = W 2A [ SD( R A)]2 + W 2B [ SD( R B )]2 + 2 W A W B SD( R A )SD( R B )

=0.3*0.3*225+0.7*0.7*256+2*0.3*0.7*72
=175.93
Therefore risk is 13.26%

QUESTION THREE
(a) Differentiate Fama and French Model from Arbitrage Pricing Theory (APT) (7 Marks)
(b) Differentiate Security Market Line from Capital Market Line (6 Marks)
(c) Using diagrammatical illustrations (where necessary) and examples briefly explain the
following concepts as they are used in Portfolio Management.
(i) Capital Market Line (3 marks)
(ii) Security Market Line (3 marks)
(iii) Systematic Risks (3 marks)
(iv) Market timing (3 marks)

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QUESTION FOUR

(a) Briefly explain any four applications of Capital Asset Pricing Model (CAPM) (6 Marks)

(b) The return on the risk free asset is 6 percent and the expected rate of return on a risky
portfolio is 15 per cent with a standard deviation of 20 per cent. What will be the expected
return and risk of a portfolio made up of 40 per cent of the risk free asset and 60 per cent
of the risky portfolio? (10 Marks)
(c) If the risk-free rate is 6 per cent and the expected rate of return on the market portfolio is
14 per cent. Is a security with a beta of 1.25 and an expected rate of return of 16 per cent
overpriced, under-priced or correctly valued? (9 Marks)