Assignment 2

You manage a risky portfolio with an expected rate of return of 18 percent and a standard deviation of 28
percent. The T-bill rate is 8 percent. Use these data for problems 10–19.

10. Your client chooses to invest 70 percent of a portfolio in your fund and 30 percent in a T-bill money market
fund. What is the expected value and standard deviation of the rate of return on your client's portfolio?

11. Suppose that your risky portfolio includes the following investments in the given proportions:

What are the investment proportions of your client's overall portfolio, including the position in T-bills?

12. What is the reward-to-volatility ratio (S) of your risky portfolio? Your client's?

13. 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.

14. 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 percent.

1. What is the proportion y?

2. What are your client's investment proportions in your three stocks and the T-bill fund?

3. What is the standard deviation of the rate of return on your client's portfolio?

15. Suppose that your client prefers to invest in your fund a proportion y that maximizes the expected return on
the overall portfolio subject to the constraint that the overall portfolio's standard deviation will not exceed
18 percent.

1. What is the investment proportion (y)?

2. What is the expected rate of return on the overall portfolio?

16. Your client's degree of risk aversion is A = 3.5.

1. What proportion (y) of the total investment should be invested in your fund?

2. What is the expected value and standard deviation of the rate of return on your client's optimized
portfolio?
 You estimate that a passive portfolio (i.e., one invested in a risky portfolio that mimics an index) yields an
expected rate of return of 13 percent with a standard deviation of 25 percent. Continue to assume that rf = 8
percent.

17. Draw the CML and your fund's CAL on an expected return–standard deviation diagram.

1. What is the slope of the CML?

2. Characterize in one short paragraph the advantage(s) of your fund over the passive fund.

18. our client ponders whether to switch the 70 percent that is invested in your fund to the passive portfolio.

1. Explain to your client the disadvantage(s) of the switch.

2. Show your client the maximum fee you could charge (as a percentage of the investment in your
fund deducted at the end of the year) that would still leave him or her at least as well off investing
in your fund as in the passive one. (Hint: The fee will lower the slope of your client's CAL by
reducing the expected return net of the fee.)

19. Consider the client in problem 16 with A = 3.5.

1. If the client chose to invest in the passive portfolio, what proportion (y) would be selected?

2. Is the fee (percentage of the investment in your fnd, deducted at the end of the year) that you can
charge to make the client indifferent between your fund and the passive strategy affected by her
capital allocation decision?

26. Consider the following information about a risky portfolio that you manage, and a risk-free asset: E(rP) =
11%, σP = 15%, rf = 5%.

1. Your client wants to invest a proportion of her total investment budget in your risky fund to
provide an expected rate of return on her overall or complete portfolio equal to 8 percent. What
proportion should she invest in the risky portfolio, P, and what proportion in the risk-free asset?

2. What will be the standard deviation of the rate of return on her portfolio?

3. Another client wants the highest return possible subject to the constraint that you limit his standard
deviation to be no more than 12 percent. Which client is more risk-averse?
27. Investment Management Inc. (IMI) uses the capital market line to make asset allocation recommendations.
IMI derives the following forecasts:

1. Expected return on the market portfolio: 12%

2. Standard deviation on the market portfolio: 20%

3. Risk-free rate: 5%

Samuel Johnson seeks IMI's advice for a portfolio asset allocation. Johnson informs IMI that he wants the
standard deviation of the portfolio to equal half of the standard deviation for the market portfolio. Using the
capital market line, what expected return can IMI provide subject to Johnson's risk constraint?

The following problems are based on questions that have appeared in past CFA examinations.

29. On the basis of the utility formula above, which investment would you select if you were risk-averse?

30. On the basis of the utility formula above, which investment would you select if you were risk-neutral?

31. The variable A in the utility formula represents the

1. Investor's return requirement

2. Investor's aversion to risk

3. Certainty-equivalent rate of the portfolio

4. Preference for one unit of return per four units of risk

Use the following graph in answering problems 32 to 37.

32. Which indifference curve represents the greatest level of utility that can be achieved by the investor?

33. Which point designates the optimal portfolio of risky assets?

34. Given $100,000 to invest, what is the expected risk premium in dollars of investing in equities versus risk-
free T-bills on the basis of the following table?

35. The change from a straight to a kinked capital allocation line is a result of the

1. Reward-to-volatility ratio increasing

2. Borrowing rate exceeding the lending rate

3. Investor's risk tolerance decreasing

4. Increase in the portfolio proportion of the risk-free asset

36. You manage an equity fund with an expected risk premium of 10 percent and an expected standard -
deviation of 14 percent. The rate on Treasury bills is 6 percent. Your client chooses to invest $60,000 of her
portfolio in your equity fund and $40,000 in a T-bill money market fund. What is the expected return and
standard deviation of return on your client's portfolio?

37. What is the reward-to-volatility ratio for the equity fund in problem 36?
ANSWERS
Ch 6 answers questions for review

10. Expected return = .3  8% + .7  18% = 15% per year

Standard deviation = .7  28% = 19.6%
11. Investment proportions:
30.0% in T-bills
.7  27% = 18.9% in stock A
.7  33% = 23.1% in stock B
.7  40% = 28.0% in stock C
12. Your reward-to-variability ratio = = .3571
Client’s reward-to-variability ratio = = .3571
13.

30

25
CA L (Slope = .3571)
20

E(r) P
15
% Client
10

0
0 10 20 30 40



14. a. E(rC) = rf + [E(rP) – rf] y = 8 + 10y

If the expected return of the portfolio is equal to 16 percent, then solving for y we get
16 = 8 + 10y, and y = = .8
Therefore, to get an expected return of 16 percent the client must invest 80 percent of
total funds in the risky portfolio and 20 percent in T-bills.
 b. Investment proportions of the client’s funds:
20% in T-bills
.8  27% = 21.6% in stock A
.8  33% = 26.4% in stock B
.8  40% = 32.0% in stock C
c. C = .8  P = .8  28% = 22.4% per year

15. a. C = y  28%. If your client wants a standard deviation of 18 percent at most, then

y = 18/28 = .6429 = 64.29% in the risky portfolio.

b. E(rC) = 8 + 10y = 8 + .6429  10 = 8 + 6.429 = 14.429%
16. a.
y* = = = = .3644
So the client’s optimal proportions are 36.44 percent in the risky portfolio and 63.56
percent in T-bills.
b. E(rC) = 8 + 10y* = 8 + .3644  10 = 11.644%
C = .3644  28 = 10.20%
17. a. Slope of the CML = = .20
The diagram is below.
b. My fund allows an investor to achieve a higher mean for any given standard deviation
than would a passive strategy, that is, a higher expected return for any given level of
risk.

CML and CAL

18
16 CA L: Slope = .3571
14
Expected Retrun

12
10
CML: Slope = .20
8
6
4
2
0
0 10 20 30
Standard Deviation

18. a. With 70 percent of his money in my fund’s portfolio the client gets a mean return of
15 percent per year and a standard deviation of 19.6 percent per year. If he shifts that
money to the passive portfolio (which has an expected return of 13 percent and
standard deviation of 25 percent), his overall expected return and standard deviation
become
E(rC) = rf + .7[E(rM)  rf]

In this case, rf = 8% and E(rM) = 13%. Therefore,

E(rC) = 8 + .7  (13 – 8) = 11.5%
The standard deviation of the complete portfolio using the passive portfolio would be
C = .7  M = .7  25% = 17.5%
 Therefore, the shift entails a decline in the mean from 14 percent to 11.5 percent and
a decline in the standard deviation from 19.6 percent to 17.5 percent. Since both
mean return and standard deviation fall, it is not yet clear whether the move is
beneficial or harmful. The disadvantage of the shift is that if my client is willing to
accept a mean return on his total portfolio of 11.5 percent, he can achieve it with a
lower standard deviation using my fund portfolio, rather than the passive portfolio.
To achieve a target mean of 11.5 percent, we first write the mean of the complete
portfolio as a function of the proportions invested in my fund portfolio, y:
E(rC) = 8 + y(18  8) = 8 + 10y
Because our target is: E(rC) = 11.5%, the proportion that must be invested in my fund
is determined as follows:
11.5 = 8 + 10y, y = = .35
The standard deviation of the portfolio would be: C = y  28% = .35  28% = 9.8%.
Thus, by using my portfolio, the same 11.5 percent expected return can be achieved
with a standard deviation of only 9.8 percent as opposed to the standard deviation of
17.5 percent using the passive portfolio.
b. The fee would reduce the reward-to-variability ratio, that is, the slope of the CAL.
Clients will be indifferent between my fund and the passive portfolio if the slope of
the after-fee CAL and the CML are equal. Let f denote the fee.
Slope of CAL with fee = =
Slope of CML (which requires no fee) = = .20. Setting these slopes equal we get
= .20
10  f = 28  .20 = 5.6
f = 10  5.6 = 4.4% per year
19. a. The formula for the optimal proportion to invest in the passive portfolio is
y* =
With E(rM) = 13%; rf = 8%; M = 25%; A = 3.5, we get

y* = = .2286
b. The answer here is the same as in 9(b). The fee that you can charge a client is the
same regardless of the asset allocation mix of your client’s portfolio. You can charge
a fee that will equalize the reward-to-variability ratio of your portfolio with that of
your competition.

.08  .05
26. a. E(rC) = 8% = 5% + y × (11% – 5%)  y  0.5
.11  .05
b. σC = y × σP = .50 × 15% = 7.5%
 c. The first client is more risk-averse, allowing a smaller standard deviation.
27. Johnson requests the portfolio standard deviation to equal one-half the market portfolio
standard deviation. The market portfolio  M 20% , which implies  P 10% . The
intercept of the CML equals rf 0.05 and the slope of the CML equals the Sharpe ratio
for the market portfolio (35%). Therefore using the CML:
E (rM )  rf
E (rP ) rf   P 0.05  0.35 0.10 0.085 8.5%
M

29. 3. [Utility for each portfolio = E(r) – .005 × 4 × 2. We chose the portfolio with the
highest utility value.]
30. 4. [When investors are risk-neutral, A = 0, and the portfolio with the highest utility is the
one with the highest expected return.]
31. b [Investor’s aversion to risk]
32. Indifference curve 2
33. Point E
34. (.6 × $50,000) + [.4 × ($30,000)]  $5,000 = $13,000
35. (b)
36.
Expected return for equity fund = T-bill rate + risk premium = 6% + 10% = 16%
Expected rate of return of the client’s portfolio = (.6 × 16%) + (.4 × 6%) = 12%
Expected return of the client’s portfolio = .12 × $100,000 = $12,000 (which implies
expected total wealth at the end of the period = $112,000)
Standard deviation of client’s overall portfolio = .6 × 14% = 8.4%
.10
37. Reward-to-volatility ratio = 0.71
.14