Tutorial 4

IN-CLASS EXERCISE 1
Citigroup made the weighting recommendations to a client regarding estimations of the
following 3 assets at the year end 2019:
Asset Expected Return Standard Deviation Weights
Stock HYA 20% 30% 50%
Stock HLT 15% 20% 30%
Treasury Bills 3% 0% 20%

At the year end 2020, after the outbreak of COVID-19, the investment landscape changed
and the new estimations of the 3 assets become the followings:

Asset Expected Return Standard Deviation

Stock HYA 10% 20%
Stock HLT 5% 10%
Treasury Bills 1% 0%

It is estimated that there is no co-movement between stock HYA and stock HLT. The investor
prefers to have maintain the same proportion of both stocks in the same risky portfolio as they
are the gifts from his parents. What recommendations Citigroup should make to the client
regarding the above 3 assets in the client’s overall portfolio at the year end 2020?

∗
1 − y2020 = wf,2020 = 𝟗. 𝟔𝟏%

wHYA,2020 = 𝟓𝟔. 𝟒𝟗%

wHYA,2020 = 𝟑𝟑. 𝟗𝟎%

Tutorial 4
Tutorial 4

SELF-STUDY PROBLEM SET 1

Which of the following choice best completes the following statement? An investor with a
higher degree of risk aversion, compared to one with a lower degree, will prefer combined
portfolios
a. that are riskier.
b. with lower Sharpe ratios.
c. with higher Sharpe ratios.
d. None of the above is true.

SELF-STUDY PROBLEM SET 2

Which of the following statement is true?
a. A lower allocation to the risky portfolio reduces the Sharpe ratio.
b. A portfolio with borrowing at risk-free rate has the same Sharpe ratio as a portfolio
without borrowing.
c. With a fixed risk-free rate, doubling the expected return and standard deviation of the
risky portfolio will double the Sharpe ratio.
d. Holding constant the risk premium of the risky portfolio, a higher risk-free rate and
volatility will increase the Sharpe ratio of investments with a positive allocation to the
risky asset.

SELF-STUDY PROBLEM SET 3

Use the following graph to answer the following questions.

a. Which indifference curve represents the greatest level of utility that can be achieved by
the investor?
Indifference curve 2
b. Which point designates the combined portfolio (C) for the investor?
Point F

Tutorial 4
Tutorial 4

SELF-STUDY PROBLEM SET 4

IMI uses the capital allocation line to make asset allocation recommendations. IMI derives
the following forecasts:
▪ Expected return on the risky portfolio: 12%
▪ Standard deviation on the risky portfolio: 20%
▪ 1-month T-bill rate: 5%

A client seeks IMI’s advice for a portfolio asset allocation and informs IMI that for every $5
he invests in the risky portfolio, he would borrow $2 further to invest. What expected return
and standard deviation can IMI provide subject to client’s investment constraint?
$5 + $2
y= = 1.4
$5

E(R C ) = y E(R p ) + (1 − y)R f

= 1.4 × 12% + (−0.4) × 5% = 𝟏𝟒. 𝟖%

σC = 20% × 1.4 = 𝟐𝟖%

SELF-STUDY PROBLEM SET 5

Use the following data in answering a and b:

a. Based on the utility formula above, which investment would you select if you were risk
averse with A = 4?
Utility for each investment = E(R) – 1/2 × 4 × σ2

Expecte Standard
Utility
Investment d return deviation
U
E(R) 
1 0.12 0.30 -0.0600
2 0.15 0.50 -0.3500
3 0.21 0.16 0.1588
4 0.24 0.21 0.1518
We choose the investment with the highest utility value, Investment 3.

Tutorial 4
Tutorial 4

b. Based on the utility formula above, which investment would you select if you were risk
neutral?
When investors are risk neutral, then A = 0; the investment with the highest utility is
Investment 4 because it has the highest expected return.

SELF-STUDY PROBLEM SET 6

Consider a risky portfolio that offers an expected rate of return of 12% and a standard
deviation of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level of
risk aversion for which the risky portfolio is still preferred to bills?
UP = 0.12 – 1/2 × A × 0.182
= 0.12 – 0.0162A
In order for the risky portfolio to be preferred to bills, the following must hold:
0.12 – 0.0162A > 0.07
A < 0.05/0.0162
A < 3.09

Tutorial 4
Tutorial 4

SELF-STUDY PROBLEM SET 7

The average annual rate of return on the S&P 500 portfolio over the past 80 years has
averaged roughly 8% more than the Treasury bill return and that the S&P 500 standard
deviation has been about 20% per year. Assume these values are representative of investors’
expectations for future performance and that the current T-bill rate is 5%.
a. Calculate the expected return and standard deviation of portfolios invested in T-bills and
the S&P 500 index with weights as follows:

The portfolio expected return and variance are computed as follows:

(1) (2) (3) (4) rPortfolio Portfolio 2
WBills rBills WIndex rIndex (1)×(2)+(3)×(4) (3) × 20% Portfolio

0.0 5% 1.0 13.0% 13.0% = 0.130 20% = 0.20 0.0400

0.2 5% 0.8 13.0% 11.4% = 0.114 16% = 0.16 0.0256
0.4 5% 0.6 13.0% 9.8% = 0.098 12% = 0.12 0.0144
0.6 5% 0.4 13.0% 8.2% = 0.082 8% = 0.08 0.0064
0.8 5% 0.2 13.0% 6.6% = 0.066 4% = 0.04 0.0016
1.0 5% 0.0 13.0% 5.0% = 0.050 0% = 0.00 0.0000

b. Calculate the utility levels of each portfolio from part a. for an investor with A = 2 and
A = 3. What do you conclude?
Computing utility from U = E(r) – 1/2Aσ2 = E(r) – σ2, we arrive at the values in the
column labeled U(A = 2) in the following table:
WBills WIndex rPortfolio Portfolio 2Portfolio U(A = 2) U(A = 3)
0.0 1.0 0.130 0.20 0.0400 0.0900 .0700
0.2 0.8 0.114 0.16 0.0256 0.0884 .0756
0.4 0.6 0.098 0.12 0.0144 0.0836 .0764
0.6 0.4 0.082 0.08 0.0064 0.0756 .0724
0.8 0.2 0.066 0.04 0.0016 0.0644 .0636
1.0 0.0 0.050 0.00 0.0000 0.0500 .0500
The column labeled U(A = 2) implies that investors with A = 2 prefer a portfolio that is
invested 100% in the market index to any of the other portfolios in the table.

The column labeled U(A = 3) in the table above is computed from:

U = E(r) – 0.5Aσ2 = E(r) – 1.5σ2
The more risk averse investors prefer the portfolio that is invested 60% in the market
index, rather than the 100% market weight preferred by investors with A = 2.

Tutorial 4
Tutorial 4

SELF-STUDY PROBLEM SET 8

You manage a risky portfolio with expected rate of return of 18% and standard deviation of
28%. The T-bill rate is 8%.
a. Your client chooses to invest 70% of a portfolio in your fund and 30% in a T-bill money
market fund. What is the expected value and standard deviation of the rate of return on
his portfolio?
E(R C ) = 70% × 18% + 30% × 8% = 𝟏𝟓%
σC = 70% × 28% = 𝟏𝟗. 𝟔%

b. Suppose that your risky portfolio includes the following investments in the given
proportions:
Stock A 25%, Stock B 32%, Stock C 43%

What are the investment proportions of your client’s overall portfolio, including the
position in T-bills?
Investment proportions: T-bill money market Fund = 30%
Stock A 70% × 25% = 𝟏𝟕. 𝟓%
Stock B 70% × 32% = 𝟐𝟐. 𝟒%
Stock C 70% × 43% = 𝟑𝟎. 𝟏%

c. What is the reward-to-volatility ratio (S) of your risky portfolio? Your client’s?
18% − 8%
SP = = 𝟑𝟓. 𝟕𝟏%
28%
15% − 8%
SC = = 𝟑𝟓. 𝟕𝟏%
19.6%

d. Draw the CAL of your portfolio on an expected return–standard deviation diagram.

What is the slope of the CAL? Show the position of your client on your fund’s CAL.

30
CAL (Slope = 0.3571)
25

20

E(r) P
15
% Client
10

0
0 10 20 30 40

 ()

Tutorial 4
Tutorial 4

e. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.
▪ What is the proportion y?
E(R C ) = R f + y[E(R p ) − R f ]
16% = 8% + y[18% − 8%]
y = 𝟖𝟎%

▪ What are your client’s investment proportions in your three stocks and the T-bill
fund?
Investment proportions: T-bill money market Fund = 20%
Stock A 80% × 25% = 𝟐𝟎%
Stock B 80% × 32% = 𝟐𝟓. 𝟔%
Stock C 80% × 43% = 𝟑𝟒. 𝟒%

▪ What is the standard deviation of the rate of return on your client’s portfolio?
σC = 80% × 28% = 𝟐𝟐. 𝟒%

f. Suppose that your client prefers to invest in your fund a proportion y that maximizes the
expected return on the complete portfolio subject to the constraint that the complete
portfolio’s standard deviation will not exceed 18%.
▪ What is the investment proportion, y?
18% = y 28%
y = 64.29%

▪ What is the expected rate of return on the complete portfolio?

E(R C ) = 8% + 64.29%[18% − 8%]
E(R C ) = 𝟏𝟒. 𝟒𝟑%

g. The client degree of risk aversion is A = 3.5

▪ What proportion, y, of the total investment should be invested in your fund?
E(R p ) − R f
y∗ =
Aσp 2
18% − 8%
= = 𝟑𝟔. 𝟒𝟒%
3.5 × 28%2

▪ What is the expected return and standard deviation of the rate of return on your
client’s optimized portfolio?

E(R C ) = 8% + 36.44%[18% − 8%] = 𝟏𝟏. 𝟔𝟒%

σC = 36.44% × 28% = 𝟏𝟎. 𝟐𝟎%

Tutorial 4