FINANCIAL ECONOMICS 2018/19

SEMINAR 1: PORTFOLIO THEORY

1. Exam December 2009/10

Let us assume a one-period economy with 2 risky assets, A and B. Asset A has a rate of return
with mean 20% and standard deviation (or volatility) 35%. Asset B has a rate of return with
mean 10% and volatility 15%. The correlation between both returns is 0.5.

a) If you had €1,000 and you wanted a 15% expected return, how would you invest your
money in both assets? Which is the return volatility of that portfolio?
b) If you had €1,000 and you wanted your portfolio return to have a volatility of 20%, in
which 2 portfolios of both assets could you invest your money? Which of the 2
portfolios would an investor with mean-variance preferences choose?
 
Hint: The solution of ax 2 + bx + c = 0 is x = −b ± b2 − 4ac  2a .
 

a)

The expected return must satisfy ω * 20 + (1-ω) * 10 = 15, where ω is the fraction of wealth
invested in A. From that equation we obtain ω = 0.5. Therefore, we must invest 500 euros in A
and 500 in B.

The covariance between the two assets is 0.5 * 35 * 15 = 262.50.

The volatility will be the square root of 0.52 * 352 + 0.52 * 152 + 2 * 0.5 * 0.5 * 262.50 = 493.75,
that is, 22.22%.

b)

The variance of the portfolio should be 202 = ω 2 * 352 + (1-ω) 2 * 152 + 2 * ω * (1-ω) * 262.50.

Therefore, we must solve the equation 925 ω 2+ 75ω-175= 0. We know that the roots are 0.396
and -0.477.

The first portfolio has an expected return of 0.396 * 20 + 0.604 * 10 = 13.96%, while the
second has an expected return of -0.477 * 20 + 1.477 * 10 = 5.23%. The efficient portfolio is
the first one, and therefore we will invest 396 euros in A and 604 in B.

2. September Exam 2009/10

Consider an economy with one safe asset and one risky asset. The safe asset is a zero coupon
bond maturing in 1 year with a nominal of 100 euro and a price of 95,24 euro. The risky asset is
stock with a price today of 90,91 euro, and whose value in t=1 is a random variable with mean
100 euro and standard deviation 9,09 euro.

a) Translate the previous information into returns. In other words, show that the annual
interest rate of the bond is 5%, and the stock return has an expected value of 10% and
a standard deviation (or volatility) of 10%.

b) Draw the efficient mean-variance frontier of this economy.

c) What is the Sharpe ratio of the risky efficient portfolios?

d) A portfolio invests 150% in the bond and -50% in stock. Is this efficient?

e) Now consider instead an economy without the riskless asset , but with many risky
assets (for example, shares in other companies). Assume that the correlation between
their returns is 0. What happens to the return volatility of a portfolio with equal weight
in every risky asset as we add more and more assets to it?

a)

The translation to annual returns is r = (100 / 95.24) -1 = 0.05 for the bond, that is, an
annual interest rate of 5%. In the case of the share we have R = (X / 90.91) -1 where X is the
value in one year. Given the data, we have that E (R) = (100 / 90.91) -1 = 0.10, or expected
return of 10%, and SDev (R) = 9.09 / 90.91 = 0.10, or volatility of 10%.

c)

This ratio is unique and equal to that of the stock, S = (10-5) /10=0.5.

d)

The expected return is 1.5 * 5-0.5 * 10 = 2.5%, while the volatility is 0.5 * 10 = 5%. Given
the data, this portfolio would be located in the inefficient part of the mean-variance
frontier, so it would not be chosen by a mean-variance agent.

e)

Portfolio volatility not just decreases with diversification, but it actually becomes zero
because all correlations are zero. Proof:
 J  1 2 J J  1  2
=σ c2 2
∑   σ j + ∑ ∑   σ ij
=j 1  J  =i 1 =j 1  J 
i≠ j

 
1 1 J 2 J −1  1 J J 
=  ∑σj+  J ( J − 1) =i∑1 =j∑1σ ij 
J  J =j 1  J

 i≠ j 

1 2 J −1
= σj + σ ij
J J
3. June Exam 2010/11

Consider an economy with two dates (1 period), with two risky assets, A and B. Asset A has a
rate of return with mean 12% and a volatility of 20%, while asset B has a rate of return with
mean 15% and a volatility of 25%. The correlation between the returns of asset A and asset B is
1.

a) Express the expected return on a portfolio composed of the two risky assets as a
function of the expected returns on each asset. Do the same for the volatility
(standard deviation) of the portfolio (as function of the volatilities of each asset).
Represent the efficient frontier in the mean-standard deviation space. Locate
assets A and B on the graph.

b) Assume the correlation between the returns on asset A and the returns on asset B
is 0 (not 1 as before!). Compute the expected return, volatility and the Sharpe ratio
of a portfolio, M, that invests 52.23% in asset A and the rest in asset B if we
introduce a bond paying a risk-free interest rate of 5%.

a) Ep=ωA*EA+(1-ωA)*EB

As ρ=1, and no short selling is allowed (0≤ωA≤1), we obtain that:

σP=ωA*σA+(1-ωA)*σB

Both the expected return on the portfolio and the volatility of the portfolio are weighted sums of the
returns, respectively volatilities, of the risky assets.

Graphically, the frontier is as follows:

Point A corresponds to a portfolio in which we invest everything in asset A, ωA=1. Point B corresponds to
investing everything in asset B, ωA=0.

b) EM=0.5223*EA+(1-0.5223)*EB

EM=0.5223*12+(1-0.5223)*15=13.43%

As covariance between the two assets is now zero, we obtain:

σ2M=ω2A σ2A+ (1- ωA)2σ2B= 251.74222

σM=15.86%

Sharpe = 0.5315

4. July 2016

Consider an economy with one period and two dates (t=0, t=1), a bond (asset 0) and two risky
assets (assets 1 and 2). The risk-free rate paid by the bond (interest rate) is r=5%. The risky asset
returns and characteristics are given in the table below:

Volatility (σj) Expected return

E(Rj)

Asset 1 6 6,08

Asset 2 23,32 15,88

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

4.1-Which of the following portfolios is the tangency portfolio?

• Portfolio A: 20% in Asset 1, 80% in Asset 2

• Portfolio B: 60% in Asset 1, 40% in Asset 2
• Portfolio C: 80% in Asset 1, 20% in Asset 2

4.2-Calculate the efficient portfolio for an expected return of 12%. Define clearly the
investment position in each of the 3 assets.

4.3-What is the expected return of an efficient portfolio with the same volatility as asset 1
(σ=6%)?

4.1

A: 20% in 1, 80% in 2
E(R ) = 13,92%, vol = 18,69%, Sharpe = 0.477
B: 60% en Activo 1, 40% en Activo 2
E(R ) = 10%, vol = 10%, Sharpe = 0.5
 C: 80% en Activo 1, 20% en Activo 2
E(R ) = 8,04%, vol = 6,69%, Sharpe = 0.4542
4.2

wM = 1.4; w1 = 0.84, w2 = 0.56, w0 = -0.4

4.3

E(R ) = 0.05 + 0.5 * 0.06 = 0.08