Campus de Gualtar

4710-057 Braga – P School of Economics and Management

Financial Investments

Exercises – Chapter 4 (part II)

1. Consider a market where investors can invest in the following assets:

Asset E[R] Standard Deviation
X 8% 15%
Y 20% 25%

The correlation between the two assets is -0.5.

a. What is the proportion we should invest in X that will result in a portfolio with an expected
return of 15%? What is the standard deviation of the portfolio?
0.15 = 𝑤𝑥 × 0.08 + (1 − 𝑤𝑥 )0.2
𝑤𝑥 = 0.416667
𝑤𝑦 = 1 − 0.416667 = 0.58333
Standard deviation of the portfolio:
𝜎𝑝2 = (0.416667)2 (0.15)2 + (0.58333)2 (0.25)2
+ 2 × (0.416667) × (0.58333) × −0.5 × 0.15 × 0.25
𝜎𝑝2 = 0.016059
𝜎𝑝 = 0.1267
b. What is the proportion we should invest in X that will result in a portfolio with a standard
deviation of 20%? What is the expected return of the portfolio?
(0.2)2 = (𝑤𝑥 )2 (0.15)2 + (1 − 𝑤𝑥 )2 (0.25)2 + 2 × (𝑤𝑥 ) × (1 − 𝑤𝑥 ) × −0.5 × 0.15 × 0.25
𝑤𝑥 = 0.1571
𝑤𝑦 = 1 − 0.1571 = 0.8429
Expected return = 0.1571 × 0.08 + 0.8429 × 0.2 = 0.1812
[Note: The other solution is 𝑤𝑥 = 1.1695]

c. What is the proportion we should invest in X that will result in the minimum variance
portfolio? What is the expected return and standard deviation of this portfolio?
𝜎𝑦2 − 𝜎𝑥 𝜎𝑦 𝜌𝑥𝑦
𝑤𝑥 = 2
𝜎𝑥 + 𝜎𝑦2 − 2𝜎𝑥 𝜎𝑦 𝜌𝑥𝑦
 (0.25)2 − 0.15 × 0.25 × −0.5
𝑤𝑥 = = 0.66327
(0.15)2 + (0.25)2 − 2 × 0.15 × 0.25 × −0.5
𝑤𝑦 = 1 − 0.66327 = 0.33673

𝐸[𝑅𝑝 ] = 0.66327 × 0.08 + 0.33673 × 0.2 = 0.12041

𝜎𝑝2 = (0.66327)2 (0.15)2 + (0.33673)2 (0.25)2
+ 2 × (0.66327) × (0.33673) × −0.5 × 0.15 × 0.25
𝜎𝑝 = 0.09279

2. What is the beta of each of the following stocks:

Stock return Stock return When the market

Stock if market return is -10% if market return is 10% varies 20%, the 
stock varies
A 0 20% 20 1
B -20% 20% 40 2
C -30% 0 30 1.5
D 15% 15% 0 0
E 10% -10% -20 -1

3. Investors expect the market rate of return this year to be 10%. The expected rate of return on
a stock with a beta of 1.2 is currently 12%. If the expectation on the market return this year
changes out to be 8%, how would revise your expectation of the rate return on the stock?

The beta of a stock measures the sensitivity of the stock to market movements. It is the amount
by which the security return tends to increase or decrease for every 1% increase or decrease
in the return of the market.

In this case, the beta of the stock is 1.2, meaning that for every 1% change in the market, the
stock will change by 1.2%. In this case, the market return decreases 2%, the return of the stock
will decrease 2 x 1.2% = 2.4%
Therefore, the expected rate of return on the stock should be revised to: 12% – 2.4% = 9.6%

4. Suppose that the market model for the excess returns of stocks A and B is estimated as follows:
RA = 0.01 + 0.9Rm + A
RB = -0.02 + 1.1Rm + B
You also know that:
Residual standard deviation, s(A)= 30%
Residual standard deviation, s(B)= 10%
M = 20%
Calculate the standard deviation of each stock.
Stock A: 𝜎𝐴2 = (0.9)2 (0.2)2 + (0.3)2 = 0.0324 + 0.09 = 0.1224
𝜎𝐴 = 0.35
 Stock B: 𝜎𝐵2 = (1.1)2 (0.2)2 + (0.1)2 = 0.0484 + 0.01 = 0.0584
𝜎𝐵 = 0.24

5. The standard deviation of the market index portfolio is 20%. Stock A has a beta of 1.5 and a
residual standard deviation of 30%. What would make for a larger increase in the stock’s
variance: an increase of 0.15 in its beta or an increase of 3% (from 30 to 33%) in its residual
standard deviation?

Total variance = Systematic variance + Residual variance = β2 Var(r ) + Var(e)

M

When β = 1.5 and σ(e) = .3, variance = 1.52 × 0.22 + 0.32 = 0.18. In the other scenarios:

m 20% 20% 20%

 1.5 1.65 1.5
e 30% 30% 33%
variance 18.00% 19.89% 19.89%

Both will have the same impact. Total variance will increase from .18 to .1989

6. Consider the following risky portfolios:

A B C D E F G H
E(r) % 10 12.5 15 16 17 18 18 20
p % 23 21 25 29 29 32 35 45

a. Plot these risky portfolios on a graph.

b. Five of these portfolios are efficient, and three are not. Which are inefficient? A, D, G

c. Suppose you can also invest in T-Bills and obtain an interest rate of 12%. Which of the
above portfolios has the highest Sharpe ratio?
A B C D E F G H
Sharpe -0.087 0.024 0.120 0.138 0.172 0.188 0.171 0.178

d. Suppose you are prepared to tolerate a standard deviation of 25%. What is the maximum
expected return that you can achieve if you cannot borrow or lend at the risk-free rate?

15% in C
 e. What is your optimal strategy if you can invest in T-Bills with a return of 12% and are
prepared to tolerate a standard deviation of 25%? What is the maximum expected return
that you can achieve with this risk?

0.25 = 𝑦 × 0.32

𝑦 = 0.78125, so 1 − 𝑦 = 0.21875
Invest 78,125% of your money in F and invest at 21.875 in T-Bills. The expected return
you will get is:
= 0.78125 × 0.18 + 0.21875 × 0.12 = 0.1669

7. Go to the Excel spreadsheet “Chap4_part2_exercise7” on Blackboard, where you will find the
monthly rates of returns for Apple – AAPL, Alphabet (the parent company of Google) – GOOGL,
the market – S&P500 and T- bills over the last five years (2016 to 2020). Perform the
regression of the market model to find the betas of Apple and Alphabet.
Using “Regression” command from Excel’s Data Analysis menu, we can run a regression of
Apple’s and Alphabet´s excess returns against those of S&P 500, and obtain the following
data. The Beta of Apple is 1.28 and the Beta of Alphabet is 0.99.

SUMMARY OUTPUT
AAPL
Regression Statistics
Multiple R 0.6509912
R Square 0.4237896
Adjusted R Square
0.4138549
Standard Error 0.066735
Observations 60

ANOVA
df SS MS F Significance F
Regression 1 0.1899786 0.1899786 42.65767 1.788E-08
Residual 58 0.2583067 0.0044536
Total 59 0.4482853

CoefficientsStandard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%
Intercept 0.0161052 0.0089301 1.8034818 0.0765072 -0.0017703 0.0339807 -0.0017703 0.0339807
S&P500 1.2843402 0.1966444 6.531284 1.788E-08 0.8907137 1.6779667 0.8907137 1.6779667

SUMMARY OUTPUT
GOOGL
Regression Statistics
Multiple R 0.7026306
R Square 0.4936897
Adjusted R Square
0.4849603
Standard Error0.0447366
Observations 60

ANOVA
df SS MS F Significance F
Regression 1 0.1131857 0.1131857 56.554267 3.914E-10
Residual 58 0.1160792 0.0020014
Total 59 0.2292649

CoefficientsStandard Error t Stat P-value Lower 95% Upper 95% Lower 95.0%Upper 95.0%
Intercept 0.0027862 0.0059864 0.4654211 0.6433728 -0.0091969 0.0147692 -0.0091969 0.0147692
S&P500 0.991342 0.1318229 7.5202571 3.914E-10 0.7274698 1.2552142 0.7274698 1.2552142