Problem Set 4

Investments, weeks 6-7

Problem 1
Assume that only two risky assets are traded in the market and that they have the following
expected returns, risks and correlation:
A B
µ 0.04 0.10
σ 0.10 0.15
ρ 0.3
A risk-free asset with r0 = 1% is also available in the market and all the assets are held by two
portfolio managers (1 and 2) who hold the following portfolios:
P1 P2
wA 0.15 0.35
wB 0.74583 0.35
w0 0.10417 0.3
a) If both investors are maximizing their mean variance utility functions with (possibly) dif-
ferent risk aversion coefficients, does the CAPM accurately describe behavior of investors in
this market?
b) Knowing that the dollar value of P1 is twice the dollar value of P2 , ascertain if the CAPM
can accurately describe the expected risk-return relation in this market.

Problem 2
There are two risky assets A and B and a risk-free security with interest rate equal to 2% listed
in the market. The performance of the risky assets in the three equally probable states of the
world is the following:
A B
ω1 14% 25%
ω2 −5% 5%
ω3 14% −4%
Two investors hold the following portfolios in equilibrium:
security I1 I2
risk-free 83.443% 17.215%
A 10.3798% 51.899%
B 6.1772% 30.886%
a) Determine the expected return and the variance of the market portfolio.
b) Compute the betas βA and βB of the two risky assets.
c) Verify if the CAPM correctly explains the equilibrium in this market.

1
Problem 3
The returns ri of the stocks i = 1, 2, 3 listed in a market evolve according to the following
process
rit = ai + bi1 F1t + bi2 F2t + bi3 F3t + it
where F1 , F2 and F3 are the factors which successfully describe returns within an APT model.
Assume that Cov(Fj , Fk ) = 0 if j, k = 1, 2, 3 and j 6= k, Cov(Fj , i ) = 0 and that E[F1 ] =
E[F2 ] = E[F3 ] = 0. A risk-free security with return rf = 2% is also available in the market.
Estimating the return generating process for the three stocks we get the following estimates for
the intercept and the exposures to the factors:

i→ 1 2 3
ai 0.04 0.06 0.07
b1 1.2 1 0.8
b2 0 0.8 1
b3 0 0 0.3

a) Compute the risk premia and the replication portfolios of the factors 1, 2, 3.

b) An asset manager is willing to launch a new fund which only invests in risky assets and
aims at exploiting the profitability of factors 2 and 3. Find the expected return µmvp and
the exposures bmvp
2 and bmvp
3 of the minimum variance portfolio with zero exposure to F1 .
Assume that the variances σF2 2 and σF2 3 of the factors are respectively 0.22 and 0.152 and
ignore the effect of non systematic risks.

c) Compute the fair price in this market of an investment I which pays a unit risky cash flow in
one year and has an exposure to systematic risks described by b1I = 0.5, b2I = 0, b3I = 0.9.