Risk Management (Assignment I)

Due: 23:59, Nov 11

1. Please list all the risk measures you learnt from this course and illustrate their differ-
ences (advantages and disadvantages).

2. Let Y and X be two random variables, with y and x denote realized values. Let
fX (x), fY |X (y | x), fX,Y (x, y) be the corresponding density functions for X, Y |X, and
for the joint distribution of X and Y .
(a) The Law of Iterated Expectations says E(Y ) = E(E(Y | X)). Prove it for the
continuous case as well as for the discrete case.
(b) Iterated expectations can be taken with nested conditioning sets. Using appropri-
ate conditional densities, show that E(Y | X) = E(E(Y | X, Z) | X).
(c) Show that E(XY ) = E(XE(Y | X)).

3. Explain the relations among Normal, Chi-Square, t and F distributions.

4. Show that: for Linear (arithmetic) returns:

Pt
Lt = −1
Pt−1

If w1 , . . . , wn are n portfolio weights of the securities in portfolio P , then

Lt,P = w1 Lt,1 + · · · + wn Lt,n

5. There are two risky assets, A and B. The expected return on asset A and B is 0.10
and 0.16. The standard deviation of returns on asset A and B is 0.18 and 0.30. The
correlation between their returns is 0.30.
(a) What are the portfolio weights on assets A and B that minimize the standard
deviation of returns?
(b) What is the minimum standard deviation? and what is the expected return of
this portfolio?

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6. Consider a market consisting of three risky assets. The expected returns on assets 1, 2,
and 3 are, respectively, 0.50, 0.70, and 0.90. The covariances are σ12 = σ22 = σ33 = 2.5,
σ12 = σ23 = 1, and σ13 = 0.
(a) Find the minimum-variance portfolio.
(b) Find the tangent portfolio when the risk-free rate is 0.05.

7. Consider four risky assets whose expected returns are r̄1 = 0.15, r̄2 = 0.18, r̄3 = 0.12,
r̄4 = 0.10. The covariance matrix
 
 0.0400 0.0080 −0.0030 0.0008 
 
 0.0080 0.0100 −0.0060 0.0320 
 
Σ=



 −0.0030 −0.0060 0.0900 −0.0480 
 
 
0.0008 0.0320 −0.0480 0.1600

(a) Determine the mean-variance efficient portfolio of risky assets that achieves an
expected rate of return of 0.20 and its standard deviation (in percent).
(b) Determine the minimum variance portfolio and its standard deviation (in percent).
(c) Suppose the risk-free rate is 0.05. Determine the tangent portfolio and its standard
deviation (in percent).

8. Assume that the expected rate of return on the market portfolio is 0.23 and the rate
of return on T-bills (the risk-free rate) is 0.07. The standard deviation of the return
on the market (tangent) portfolio is 0.32.
(a) What is the equation of the capital market line?
(b) If the expected return of 0.39 is desired, what is the standard deviation of this
position? If you had 1,000 to invest, how should you allocate it to achieve the above
position?
(c) If you invest 300 in the risk-free asset and 700 in the market portfolio, how much
money should you expect to have at the end of the year?

9. There are only two risky assets, A and B, and a risk-free asset F . The two risky
assets are in equal supply in the market; that is, the market (tangent) portfolio
2 = 0.04, σ
M = 0.5(A + B). The following information is known: rF = 0.10, σA AB =
2 = 0.02, and r̄
0.01, σB M = 0.18

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 2 , β and β .
(a) Find general expressions for σM A B

(b) According to CAPM, what are the numerical values for r̄A and r̄B ?

10. There are only two risky stocks, A and B. The number of shares outstanding, price
per share, expected rate of return, and standard deviation of return for stock A are
100, 1.50, 0.15, 0.15, respectively, and the number of shares outstanding, price per
share, expected rate of return, and standard deviation of return for stock B are
150, 2.00, 0.12, 0.10, respectively. The correlation coefficient between the returns of
stocks A and B is ρAB = 0.25. There is also a risk-free asset, and everything satisfies
the CAPM exactly.
(a) What is the expected rate of return of the market portfolio?
(b) What is the standard deviation of the market portfolio?
(c) What is the beta of stock A?
(d) What is the risk-free rate?

11. Explain whether the following statements about the CAPM are correct or not.
(a) The CAPM says that a stock with zero beta risk (no exposures to systematic risk)
should have zero return.
(b) The CAPM assumes that the beta risk of any asset is constant.
(c) The beta in CAPM is a measure of total risk exposure of a stock.
(d) According to CAPM, two stocks with the same beta must have the same return.

12. What is the difference between the security market line and the capital market line?

13. How do you understand following statements in our slides of Lecture 4-2: “The CAPM
is based on mean-variance theory and assumes that only means and variances (whose
calculations include covariances) matter in portfolio choice. This requires restrictions
on either the statistical distribution of the asset returns, such as normality, or on the
form of the utility function, such as the quadratic form”.

14. Suppose that you believe the volatility of monthly PPI (denoted as VolPt P I ) is a
relevant macroeconomic risk factor in explaining the cross-sectional stock monthly
returns. Do you know how to use Fama-MacBeth regressions to verify your belief?
Please write down the testing procedure in details.

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15. Suppose you believe that the 500 stocks in the S&P 500 index are driven by several
factors, and you have 10 years of monthly data on the returns in excess of the risk-free
interest rate. Provide a detailed approach on which you can estimate the unknown
factors and the number of factors.