SJES3467 Investment and Financial Analysis I Dec, 2011

Test 2 - Instruction to candidates

1. Answer All Questions
2. Time Allowed : 1 hour
1. Suppose that the universe of available risky securities consists of a large number of stocks, identically
distributed with E(r) = 15%, = 60%, and a common correlation coecient of = 0.5.
(a) What are the expected return and standard deviation of an equally weighted risky portfolio of
25 stocks?
(b) What is the smallest number of stocks necessary to generate an ecient portfolio with a stan-
dard deviation equal to or smaller than 43%?
(c) What is the systematic risk in this security universe?
(d) If T-bills are available and yield 10%, what is the slope of the CAL?
Solution:
The parameters are E(r) = 15%, = 60%, and the correlation between any pair of stocks is
= 0.5.
(a) The portfolio expected return is invariant to the size of the portfolio because all stocks have
identical expected returns.
The standard deviation of a portfolio with n stocks is:

P
=

1
n

2
+ 2

j
1
n
1
n
, i < j, n = 1, 2, . . .
=
_
1
n

2
+ 2
1
n
2

n(n 1)
2

2

=
_
1
n

2
+
_
1
1
n
_

(1)
Hence, the standard deviation of a portfolio with n = 25 stocks is:

P
=
_
1
25
60
2
+
24
25
60
2
0.5
= 43.27%
(b) Because the stocks are identical, ecient portfolios are equally weighted. To obtain a
standard deviation of 43%, we need to solve for n:
43
2
=
60
2
n
+ 0.5
60
2
(n 1)
n
n = 36.73
Thus we need 37 stocks and will come in with volatility slightly under the target.
Sam
SJES3467 Investment and Financial Analysis I Dec, 2011
(c) As n gets very large, the variance of an ecient (equally weighted) portfolio diminishes,
leaving only the variance that comes from the covariances among stocks, that is from
equation (1)
lim
n

P
=
_

2
=
_
0.5 60
2
= 42.43%
Note that with 25 stocks we came within 0.84% of the systematic risk, that is, the nonsys-
tematic risk of a portfolio of 25 stocks is only 0.84%. With 37 stocks the standard deviation
is 43%, of which nonsystematic risk is 0.57%.
(d) If the risk-free is 10%, then the risk premium on any size portfolio is 15 -10 = 5%. The
standard deviation of a well-diversied portfolio is (practically) 42.43%; hence the slope of
the CAL is
S = 5/42.43 = 0.1178.
Sam Page 2 of 5
SJES3467 Investment and Financial Analysis I Dec, 2011
2. Your client has a $900,000 fully diversied portfolio. She is contemplating investing in ABC Company
common stock an unspecied amount $X. You have the following information:

Expected Monthly Standard Deviation of

Returns Monthly Returns
Original Portfolio 0.67% 2.37%
ABC Company 1.25% 2.95%
Table 1: Risk and Return Characteristics
The correlation coecient of ABC stock returns with the original portfolio returns is 0.40.
Risk free T-bills are known to provide monthly returns of 0.42%
(a) Assuming that she invests in the ABC stock, calculate in terms of X the:
i. Expected return of her new portfolio which includes the ABC stock.
ii. Covariance of ABC stock returns with the original portfolio returns.
iii. Standard deviation of her new portfolio which includes the ABC stock.
(b) Calculate X which leads to she having
i. a minimum variance portfolio;
ii. an optimal risky portfolio.
(c) Identify an investment strategy which leads to an optimal risky portfolio providing a 10% in-
crease in returns from the original portfolio.
(d) Determine whether the systematic risk of her new portfolio, which includes the government
T-bill securities, will be higher or lower than that of her original portfolio.
Solution:
(a) Let W
0
= 900, 000 be the initial wealth, w
ABC
and w
OP
denote respectively the weights of
investments held in ABC stocks and the Original Portfolio, OP. We then have:
w
ABC
=
X
W
0
+X
,
w
OP
=
W
0
W
0
+X
Hence,
i. the expected return E[r
P
],of the new portfolio is given by:
E[r
P
] = w
ABC
E[r
ABC
] +w
OP
E[r
OP
]
=
X
W
0
+X
1.25 +
W
0
W
0
+X
0.67
ii. the Covariance of ABC stock returns with the original portfolio returns is given by:
Cov(r
ABC
, r
OP
) =
ABC

OP
(r
ABC
, r
OP
)
= 2.37 2.95 0.40
= 2.7966
Sam Page 3 of 5
SJES3467 Investment and Financial Analysis I Dec, 2011
iii. the Standard deviation of her new portfolio which includes the ABC stock is given by:

P
=
_
w
2
ABC

2
ABC
+w
2
OP

2
OP
+ 2 w
ABC
w
OP
Cov(r
ABC
, r
OP
)
=
_
_
X
W
0
+X
_
2
2.95
2
+
_
W
0
W
0
+X
_
2
2.37
2
+ 2
_
X
W
0
+X
__
W
0
W
0
+X
_
2.80
_1
2
=

1
(W
0
+X)
2
_
2.95
2
X
2
+ 2.37
2
W
2
0
+ 2 2.80W
0
X
_
(b) We determine the X for which:
i. the portfolio has minimum variance as follows:
d
2
dX
=
1
(W
0
+X)
2
2
_
2.95
2
X + 2.80W
0
_

2
(W
0
+X)
3
_
2.95
2
X
2
+ 2.37
2
W
2
0
+ 2 2.80W
0
X
_
Hence,
d
2
dX
=
_
2.95
2
X + 2.80W
0
_
(W
0
+X)
_
2.95
2
X
2
+ 2.37
2
W
2
0
+ 2 2.80W
0
X
_
= 0
=
_
2.95
2
2.80
_
W
0
X
_
2.37
2
2.80
_
W
2
0
= 0
i.e., X =
_
2.37
2
2.80
_
W
0
_
2.95
2
2.80
_ = 0.4772W
0
ii. the portfolio is optimal if:
w

ABC
=
E(R
ABC
)
2
OP
E(R
OP
)Cov(r
ABC
, r
OP
)
E(R
ABC
)
2
OP
+E(R
OP
)
2
ABC
[E(R
ABC
) +E(R
OP
)]Cov(r
ABC
, r
OP
)
w

OP
= 1 w

ABC
(2)
where
E(R
ABC
) = E(r
ABC
) r
f
E(R
OP
) = E(r
OP
) r
f
with r
f
= 0.42 as given in this case and from which X is obtained as
X =
1 w

OP
w

OP
W
0
We form a new portfolio including the T-bill with ABC and the Original Portfolio, OP with
the following weights:
w
Tbill
, (1 w
Tbill
)w

OP
, (1 w
Tbill
)w

ABC
(3)
where w

OP
and w

ABC
are determined using equation (2).
The optimal risky portfolio provides an expected return of E[r
RP
]:
E[r
RP
] = w

OP
0.67 +w

ABC
1.25
Sam Page 4 of 5
SJES3467 Investment and Financial Analysis I Dec, 2011
We have to determine w
Tbill
such that
w
Tbill
0.42 + (1 w
Tbill
) E[r
RP
] = 1.10 0.67 (4)
Using equation (4) the various weights listed in (3) can be calculated to enable the con-
struction of the desired portfolio.
(c) (d) As the original portfolio is said to be fully diversied, the addition of any further assets to
her existing portfolio will have no impact on the systematic risk exposures.
Sam Page 5 of 5