TUTORIAL 3- IPM

1. What do you think would happen to the expected return on stocks if investors perceived higher
volatility in the equity market? Relate your answer to Equation 6.7.
- Assuming no change in risk tolerance, that is, an unchanged risk-aversion coefficient (A), higher
perceived volatility increases the denominator of the equation for the optimal investment in the
risky portfolio (Equation 6.7). The proportion invested in the risky portfolio will therefore
decrease.
- Total risk increases=>Rf increases=> y* decreases

2. Consider a portfolio that offers an expected rate of return of 12%( là E(r) nha ) and a standard
deviation of 18% (là σ nha ) . T-bills offer a risk-free 7% rate of return. What is the maximum
level of risk aversion( là A nha ) for which the risky portfolio is still preferred to T-bills?
When we specify utility by U = E(r) – ½Aσ^2, the utility level for T-bills is: 0.07

The utility level for the risky portfolio is:

U = 0.12 - 0.5 × A × (0.18)2 = 0.12 - 0.0162 × A

In order for the risky portfolio to be preferred to bills, the following must hold:

0.12 - 0.0162A > 0.07 ⇒ A < 0.05/0.0162 = 3.09

3. Consider historical data showing that the average annual rate of return on the S&P 500
portfolio over the past 90 years has averaged roughly 9% more than the Treasury bill return
and that the S&P 500 standard deviation has been about 20% per year. Assume these values
are representative of investors’ expectations for future performance and that the current T-bill
rate is 5%.

a. Calculate the expected return and variance of portfolios invested in T-bills and the S&P
500 index with weights as follows:
Given information,
Standard deviation of market(σ)=20%
Risk - free rate of return(Rf)=5%
Market portfolio return(Rm)=5%+9%=14%=> này là rate of return đó 
If the weight of market portfolio is x and the weight of T-bill is y, the expected return (R) and variance
(V) on entire portfolio will be calculated as follows:

R=x×Rm+y×Rf
V=(x×σ)^2

Case 1: When y=0 and x=1

R=(1×0.14)+(0×0.05)= 0.14
V=(1×0.20)^2=0.04
Case 2: When y=0.2 and x=0.8
R=(0.8×0.14)+ (0.2×0.05)=0.122
V=(0.8×0.20)^2=0.0256
Case 3: When y=0.4 and x=0.6
R=(0.6×0.14)+(0.4×0.05)= 0.104
V=(0.6×0.20)^2=0.0144
Case 4: When y=0.6 and x=0.4
R=(0.4×0.14)+(0.6×0.05)= 0.086
V=(0.4×0.20)^2=0.0064
Case 5: When y=0.8 and x=0.2
R=(0.2×0.14)+(0.8×0.05)= 0.068
V=(0.2×0.20)^2=0.0016
Case 6: When y=1 and x=0
R=(0×0.14)+(1×0.05)= 0.05
V=(0×0.20)^2=0
b. Calculate the utility levels of each portfolio of Problem 10 for an investor with A = 2. What do you
conclude?+ câu c luôn nha

U(A=2) = E(r) – 0.5 × Aσ2 = E(r) – σ2

U(A=3)= E(r) – 0.5Aσ2 = E(r) – 1.5σ2

The column labelled U(A = 2) implies that investors with A = 2 prefer a portfolio that is
invested 100% in the market index to any of the other portfolios in the table.
c. Repeat Problem 11 for an investor with A = 3. What do you conclude?
The more risk averse investors prefer the portfolio that is invested 60% in the market,
rather than the 100% market weight preferred by investors with A = 2.
Use these inputs for Problems 4 through 10: You manage a risky portfolio with an expected rate
of return of 18% and a standard deviation of 28%. The T-bill rate is 9%.
4. Your client chooses to invest 70% of a portfolio in your fund and 30% in an essentially riskfree money
market fund. What is the expected value and standard deviation of the rate of return
on his portfolio?

Expected return = (0.7 × 18%) + (0.3 × 9%) = 15.3%

Standard deviation = 0.7 × 28% = 19.6%

5. Suppose that your risky portfolio includes the following investments in the given proportions:
Stock A 25% Stock B 32% Stock C 43%
What are the investment proportions of your client’s overall portfolio, including the position in Tbills?

Investment proportions:
30.0% in T-bills
0.7 × 25% = 17.5% in Stock A
0.7 × 32% = 22.4% in Stock B
0.7 × 43% = 30.1% in Stock C

6. What is the reward-to-volatility (Sharpe) ratio (S) of your risky portfolio? Your client’s?

Your reward-to-volatility (Sharpe) ratio: Slope (S)= (E(rp)-rf)/ σp= 18%-9%/28%=0.3214

Client’s reward-to-volatility (Sharpe) ratio:S=15.3%-9%/19.6%=0.3214

7. Draw the CAL of your portfolio on an expected return–standard deviation diagram. What is
the slope of the CAL? Show the position of your client on your fund’s CAL.
Này tự vẽ tay, để chỗ trống cho mà vẽ 

8. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of 16%.
a. What is the proportion y?

E(rC) = rf + y × [E(rP) – rf] = 0.09 + y × (0.18 − 0.09)

If the expected return for the portfolio is 16%, then:
16% = 9% + 9% × y ⇒y=0.77
Therefore, in order to have a portfolio with expected rate of return equal to 16%, the
client must invest 77% of total funds in the risky portfolio and 23% in T-bills.

b. What are your client’s investment proportions in your three stocks and the T-bill fund?

Client’s investment proportions:

23% in T-bills
0.77 × 25% = 19.25% in Stock A
0.77 × 32% = 24.64% in Stock B
0.77 × 43% = 33.11% in Stock C

c. What is the standard deviation of the rate of return on your client’s portfolio?
σC = 0.77 × σP = 0.77 × 28% = 21.56%
9. Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete portfolio’s
standard deviation will not exceed 18%.
a. What is the investment proportion, y?
b. What is the expected rate of return on the complete portfolio?
10. Your client’s degree of risk aversion is A = 3.5.
a. What proportion, y, of the total investment should be invested in your fund?
b. What is the expected value and standard deviation of the rate of return on your client’s optimized
portfolio?
Extra exercises:
Use the following data in answering Problems 1–3:

1. On the basis of the utility formula above, which investment would you select if you were risk
averse with A = 4?

2. On the basis of the utility formula above, which investment would you select if you were risk
neutral?
3. The variable (A) in the utility formula represents the:
a. Investor’s return requirement.
b. Investor’s aversion to risk.
c. Certainty equivalent rate of the portfolio.
d. Preference for one unit of return per four units of risk.
Use the following data in answering Problems 4–5:
4. Which indifference curve represents the greatest level of utility that can be achieved by the
investor?
5. Which point designates the optimal portfolio of risky assets?
6. The change from a straight to a kinked capital allocation line is a result of the:
a. Reward-to-volatility (Sharpe) ratio increasing.
b. Borrowing rate exceeding the lending rate.
c. Investor’s risk tolerance decreasing.
d. Increase in the portfolio proportion of the risk-free asset