Investments and Portfolio

Management Escola de Economia e Gestão

Master in Finance

Chapter 4 – Problem Sets (Part I)

1. Suppose your expectations regarding the stock price are as follows:

State of the Market Probability HPR

Boom 0.35 44.5%

Normal growth 0.30 14.0

Recession 0.35 −16.5

Compute the mean and standard deviation of the HPR on stocks.
S
E(r) = ∑s=1 p(s) r(s) = [0.35 × 44.5%] + [0.30 × 14.0%] + [0.35 × (–16.5%)]
=14%
𝑆
Var(r) = 2 = ∑𝑠=1 p(s) [ r(s) – E(r)]2 = [0.35 × (44.5 – 14)2] + [0.30 × (14 – 14)2]
+ [0.35 × (–16.5 – 14)2] = 651.175
 = 25.52%

2. XYZ stock price and dividend history is as follows:

Year Price at the beginning Dividend paid at year-
of the year end
2017 $100 $4
2018 $110 $4
2019 $90 $4
2020 $95 $4
An investor buys three shares of XYZ at the beginning of 2017, buys another two shares at
the beginning of 2018, sells one share at the beginning of 2019 and sells all four remaining
shares at the beginning of 2020.

a. What are the arithmetic and geometric average time-weighted rates of return for the
investment?
We start by computing the HPR:

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 Year Return = [(Ending Price-Beginning Price + Dividend)/Beginning Price]
2018-2017 = (110 – 100 + 4)/100 = 0.14 or 14.00%
2019-2018 = (90 – 110 + 4)/110 = –0.1455 or –14.55%
2020-2019 = (95 – 90 + 4)/90 = 0.10 or 10.00%
Arithmetic mean: [0.14 + (–0.1455) + 0.10]/3 = 0.0315 or 3.15%
1⁄
Geometric mean: [(1 + 0.14) × [1 + (–0.1455)] × (1 + 0.10)] 3 − 1 = 0.0233 or 2.33%

b. What is the dollar-weighted rate of return?

1/1/2017 1/1/2018 1/1/2019 1/1/2020

Price $100 $110 $90 $95
Net Cash Flow –300 –208 110 396

Time Net Cash flow Explanation

0 –300 Purchase of three shares at $100 per share
1 –208 Purchase of two shares at $110,
plus dividend income on three shares held (3 ×4)
2 110 Dividends on five shares (5×4)
plus sale of one share at $90
3 396 Dividends on four shares (4×4)
plus sale of four shares at $95 per share

The dollar-weighted return is the internal rate of return that sets the sum of the present
value of each net cash flow to zero:
–$208 $110 $396
0 = –$300 + + +
1+ IRR (1+ IRR)2 (1+ IRR)3

Dollar-weighted return = Internal rate of return = –0.1661%

3. Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be either
$70 000 or $200 000, with equal probabilities of 0.5. The alternative riskless investment in
T-bills pays 6%.

a. If you require a risk premium of 8%, how much will you be willing to pay for the
portfolio?
The expected cash flow is: (0.5 × $70 000) + (0.5 × 200 000) = $135 000.
With a risk premium of 8% over the risk-free rate of 6%, the required rate of return is
14%. Therefore, the present value of the portfolio is:
$135 000/1.14 = $118 421

b. Now suppose you require a risk premium of 12%. What is the price you will be willing
to pay now?
If the risk premium over T-bills is now 12%, then the required return is 6% + 12% = 18%
The present value of the portfolio is now:
$135 000/1.18 = $114 407

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 c. Comparing your answers to a) and b) what do you conclude about the relationship
between the required risk premium on a portfolio and the price at which the portfolio
will sell?
For a given expected cash flow, higher risk premiums imply lower prices. The extra
discount in the purchase price from the expected value is to compensate the investor
for bearing additional risk.

4. Consider a 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 T-bills?
U = E(r) – 0.5Aσ2, so the utility level for T-bills is: 0.07
The utility level for the risky portfolio is:
U = 0.12 – 0.5 × A × (0.18)2 = 0.12 – 0.0162 × A
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
A must be less than 3.09 for the risky portfolio to be preferred to bills.

5. Assume that you manage a risky portfolio P with an expected rate of return of 18% and a
standard deviation of 28%. The T-bill rate is 8%.

a. Your client chooses to invest 70% of a portfolio in your fund P and 30% in an
essentially risk-free money market fund. What is the expected return and standard
deviation of your client’s portfolio?
Expected return = (0.7 × 18%) + (0.3 × 8%) = 15%
Standard deviation = 0.7 × 28% = 19.6%

b. Suppose 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
positions in T-bills?
Investment
Security Proportions
T-Bills 30.0%
Stock A 0.7  25% = 17.5%
Stock B 0.7  32% = 22.4%
Stock C 0.7  43% = 30.1%

c. What is the Sharpe ratio (S) of your portfolio and your client’s overall portfolio?
𝐸(𝑟𝑝 )−𝑟𝑓 0.18−0.08
The Sharpe ratio of the risky portfolio is: = = 0.3571
𝜎𝑝 0.28

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 𝐸(𝑟𝑐 )−𝑟𝑓 0.15−0.08
The Sharpe ratio of the client’s overall portfolio is: = = 0.3571
𝜎𝑐 0.196

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

 ()

Assume the inputs of problem 5 for problems 6 to 8.

6. Suppose that your client decides to invest in your risky portfolio a proportion (y) of his total
investment budget so that his overall portfolio will have an expected rate of return of 16%?
a. What is the proportion y?
E(rC) = y  E(rP) + (1 – y)  rf

0.16 = y  0.18 + (1 – y)  0.08

Solving for y, we get y = 0.8
Therefore, in order to achieve an expected rate of return of 16%, the client must invest
80% of total funds in the risky portfolio and 20% in T-bills.

b. What are your client’s investment proportions in your three stocks and the T-bills?
The investment proportions of the client’s overall are:
Investment
Security Proportions
T-Bills 20.0%
Stock A 0.8  25% = 20.0%
Stock B 0.8  32% = 25.6%
Stock C 0.8  43% = 34.4%

c. What is the standard deviation of the rate of return on your client’s portfolio?
C = y P = 0.8  0.28 = 0.224 or 22.4%

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7. 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%.
a. What is the investment proportion, y?
σC = y × 28%
18%= y × 28%
y = 0.6429 = 64.29% invested in the risky portfolio.

b. What is the expected rate of return on the complete portfolio?

E(rC) = 0.6429  0.18 + (1 – 0.6429)  0.08 = 0.14429 = 14.429%

8. Your client’s degree of risk aversion is A = 3.5.

a. What proportion, y, of the total investment should be invested in your fund?
𝐸(𝑟𝑝 )−𝑟𝑓 0.18−0.08
𝑦∗ = = = 0.3644
𝐴𝜎𝑝2 3.5×0.282

Therefore, the client’s optimal proportions are: 36.44% invested in the risky
portfolio and 63.56% invested in T-bills.

b. What are the expected value and standard deviation of the rate of return on your
client’s optimized portfolio?
E(rC) = 0.3644×0.18 + 0.6356×0.08 = 0.1164 or 11.644%
C = 0.3644 × 0.28 = 0.10203 or 10.203%