FINANCIAL ECONOMICS

SEMINAR 2: PRICING OF RISKY ASSETS

1. June Exam 2010/11

Consider an economy with a risk-free bond (asset 0) and two risky shares (assets 1 and 2). The
return of the risk-free asset (the interest rate) is r = 5%. The properties of the returns of the
risky assets (in %) are resumed in the next table:

Volatility or standard Expected return

deviation (σj) (ERj)

Asset 1 4,81 6,08

Asset 2 23,32 15,88

Correlation between these returns = Corr(R1, R2) = ρ12 = 0

We assume that CAPM holds. The market portfolio invests 70% in asset 1 and 30% in asset
2.

a) Compute the expected return and volatility of the market portfolio. Compute the betas
of the 3 assets.

b) Represent the Capital Market Line (CML) and the three assets in the mean-standard
deviation space. Represent in another graph the Security Market Line (SML) and the
three assets.

c) Compute the efficient portfolio with an expected return of 12%, its volatility, its beta
and the fraction of the total wealth of the investor in each of the 3 assets.

d) Compute the efficient portfolio with volatility of 5%, its expected return , its beta and
the fraction of the total wealth of the investor in each of the 3 assets.

e) Compute the efficient portfolio with beta 0.5, its volatility, its expected return , its beta
and the fraction of the total wealth of the investor in each of the 3 assets.

a)
E M = ω1 E1 + ω 2 E2 = 0.09021,
σ 2 M = ω 21σ 21 + ω 2 2σ 2 2 = 0.006028 ⇒ σ M = 0.077642.

β 0 = 0,
ω1σ 21
β1 = = 0.268,
σ 2M
ω 2σ 2 2
β 2 = 2 = 2.706.
σ M

b)

The CML says that any efficient portfolio p satisfies:

E p = r + S M * σ p = 0.05 + 0.51777 * σ p .

The risky assets 1 and 2 are below the CML.

The SML says that any asset j satisfies:

E j = r + β j * (E M − r ) = 0.05 + β j * 0.0402.

We know that all assets have to be on the SML because CAPM holds.

c)

Efficient portfolios:

R = ω M RM + (1 − ω M )r ⇒ E = ω M E M + (1 − ω M )r ,
σ = ωM σ M ,
β = ωM .
 E=0.12  w M = 1.741 ; σ = 0.135195 ; w0,w1,w2= -0.74, 1.22 , 0.52

d) σ = 0.05  w M = 0.643981; E= 0.07588; w0,w1,w2= 0.356, 0.451, 0.195

e) beta=0.5  w M = 0.5; σ = 0.038821; w0,w1,w2= 0.5, 0.35, 0.15

2. June Exam 2011/12

Consider an economy with two dates (1 period) and two risky assets, A and B. Asset A has a rate
of return whose expected value is 25% and whose volatility (standard deviation) is 20%, while
asset B has a rate of return whose expected value is 10% and whose volatility is 10%. The
correlation between the returns of assets A and B is 0.

a) Calculate the expected return and volatility of the portfolios described in the table
below (portfolios C1 to C5). Plot the 5 portfolios in the mean-standard deviation space. One of
these portfolios is the minimum variance portfolio: knowing this, determine which portfolios
belong to the efficient frontier.

Portfolio C1 C2 C3 C4 C5

% weight of 100% 20% 50% 80% 0%

asset A

b) Suppose that a third asset is introduced into this economy, which has no risk and
offers a return of r=5%. Knowing that one of the 5 portfolios above is the tangent portfolio, say
which one it is and why. Assuming that all the conditions for the CAPM to hold are met, write
the equation of the Capital Market Line (CML) in this economy and plot it in a graph.

c) Given your answers to previous questions, if you are willing to hold a portfolio with a
volatility of 15%, what is the maximum expected return that you could achieve in this market?
Specify the fraction of total wealth invested in each of the three assets. (Hint: first determine
the fraction of total wealth you must invest in the tangent (market) portfolio and the riskless
asset, then, given this, the fraction of total wealth in assets A and B).

d) Assuming that the CAPM holds, calculate the betas of assets A and B with respect to
the market portfolio and check that both assets are on the Securities Market Line (SML).
 e) How would you combine the risk-free asset with the market portfolio so that the
resulting portfolio beta was 0.7?

a)

Portfolio C1 C2 C3 C4 C5
% Wealth in 100% 80% 50% 20% 0%
assets 1
ERc 0.25 0.22 0.175 0.13 0.10
SD 0.2 0.1612 0.1118 0.0894 0.10

C1, C2, C3 AND C4 ARE EFFICIENT.

0.25

0.2

0.15

0.1
0.08 0.1 0.12 0.14 0.16 0.18 0.2

b) Sharpe ratios:

1 1.0000

2 1.0543

3 1.1180

4 0.8944

5 0.5000

C3 is the tangency portfolio

Ec = 0.05 + 1,118 sigma c

c) 0.05 + 1.118 * 0.15 = 0.2177

This portfolio is obtained with an investment of (0.2177-0.05) / (0.175-0.05) = 1.3416 in the

tangent portfolio, then the weights are:

-0.3416 in ALR

0.678 in A

0.678 in B

d) beta A = 0.5 * 0.2 ^ 2 / 0.1118 ^ 2 = 1.6

beta B = 0.5 * 0.1 ^ 2 / 0.1118 ^ 2 = 0.4

0.05 + 1.6 * (0.175-0.05) = 0.25

0.05 + 0.4 * (0.175-0.05) = 0.1

e) 70% in market portfolio, 30% in asset risk book.

3. June 2016

Suppose that there exists an economy with one period (two dates, t=0 and t=1). In this economy there
are a risk-free asset and 2 risky assets (A and B). The risk-free asset offers an interest rate of 4%. Asset A
has an expected return of 20% with volatility (standard deviation) of 40%. Asset B has an expected return
of 10% and volatility of 30%. The correlation between returns of assets A and B is 0.

The market portfolio consists of 60% of asset A and 40% of asset B. Calculate the expected return,
volatility, and Sharpe ratio of the market portfolio.
Calculate the portfolio weights in each of the three assets for an investor who wants to maximize her
expected return, while assuming a volatility of 30%?
What would be the beta of the investor’s portfolio in the previous question?
Using the definition for beta as:

𝑐𝑐𝑐𝑐𝑐𝑐(𝑅𝑅𝑗𝑗 , 𝑅𝑅𝑀𝑀 )
𝛽𝛽𝑗𝑗 =
𝑣𝑣𝑣𝑣𝑣𝑣(𝑅𝑅𝑀𝑀 )

calculate the betas of assets A and B and verify that the CAPM holds in this economy.

7 E(R_{M})=0.6∗0.2+0.4∗0.1= 0.16
 var(R_{M})=0.6²∗0.4²+0.4²∗0.3²= 0.072
S_{M}=(( 0.16-0.04)/(√(0.072)))= 0.44721

8 CML:E(R_{C})=0.04+ 0.44721∗0.3= 0.17416

0.17416=w ∗0.16+(1-w)∗0.04, Solution is: 1. 118

A: 1.118∗0.6= 0.6708
B: 1.118∗0.4= 0.4472
Bono: 1-1.118= -0.118

9 beta = 1.118

10 β_{A}=((0.6∗0.4²)/( 0.072))= 1. 3333

β_{B}=((0.4∗0.3²)/( 0.072))= 0.5

E(R_{A}){CAPM}=0.04+ 1. 3333∗(0.16-0.04)= 0.2

E(R_{B}){CAPM}=0.04+ 0.5∗(.16-0.04)= 0.1

4. June 2017

Questions 8-10:: Let us suppose an economy with one period and two dates (t=0 y t=1). In this economy,
there is a risk-free asset (bond) and 2 risky assets, A and B. The bond offers a 2% interest rate. Asset A
has an expected rate of return (or yield) of 10% and a volatility (standard deviation) of 20%. Asset B has
a return of 20% and a volatility of 40%. The correlation between both returns is 0. We will assume that
the CAPM conditions hold.

Knowing that the market portfolio has weight of 64% in Asset A and 36% in Asset B, calculate the Sharpe
ratio for the Market portfolio:

SM =

What positions must an investor take if she wishes to obtain an expected return of 15% with the lowest
possible volatility?

ωBOND = ωΑ = ωΒ =

Calculate the betas of A and B:

βΑ = βΒ =
 8.

E_{M}=0.64∗0.1+0.36∗0.2= 0.136

vol_{M}=√(0.64²∗0.2²+0.36²∗0.4²)= 0.192665513 3

S_{M}=((0.136-0.02)/(0.19266))= 0.60209

9.

E_{e}=w∗0.136+(1-w)∗0.02=0.15, Solution is: {[w=1. 120689655]}

w₀=0.12

w_{A}=1.12∗0.64= 0.7168

w_{B}=1.12∗0.36= 0.4032

10.

betaA=((0.64∗0.2²)/(0.19266²))= 0.689

betaB=((0.36∗0.4²)/(0.19266²))= 1. 551

or

betaA=((0.1-0.02)/(0.136-0.02))= 0.689

betaB=((0.2-0.02)/(0.136-0.02))= 1. 551

5. June 2018

Consider a market consisting of many stocks. You have the following information for two of
those stocks, for the market portfolio and for the risk-free asset:

Expected Return (in Standard Deviation Beta

%) (in %)
Stock A 11.5 30 0.75
Stock B 4.5 10 0.25
Market Portfolio 15 15 1
Risk-free asset ? 0 0

The covariance between the returns of A and B is zero.

If the assumptions of the CAPM hold In this market, what is the risk-free interest rate?

From the CAPM equation applied to A: 0.115 = r + 0.75 x (0.15-r) -> r =0.01

If the assumptions of the CAPM hold In the market of question 2, how would you construct a
portfolio with the same beta as stock B but the minimum possible standard deviation?

Under the CAPM, all portfolios and stocks with the same beta have the same expected return,
but only one of them has minimum standard deviation: an efficient portfolio. As we know, the
beta of an efficient portfolio equals the weight of the market in that portfolio. Therefore, we
should invest 25% of our wealth in the market portfolio and 75% in the risk-free asset.