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FINS2624 problem set 5 - Tutorial question
Portfolio Management (University of New South Wales)
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PROBLEM SET 5
Q1 (Essential to cover)
The risk free rate is 4% and the following data is given about assets X and Z:
Asset E(r) σ
2
X 7% 0
%
3
0
Z 16% %
(a) What are the Sharpe ratios of the two risky assets?
(b) Show how you can dominate asset X using a portfolio that combines asset Z and the
risk free asset.
� combination = �� and E[Combination] > E[X], the Combination dominates asset X.
(c) Show how you can dominate a portfolio with equal weights in asset X and the risk-
free asset using a portfolio that combines asset Z and the risk free asset.
� (�� ) = �� + � �(�(��) – ��) = ½ × 0.03 = 0.055
� � = ���� = 0.5 × 0.2 = 0.1
If �� = ��, �� = �� �� = 0.1, �� = 0.1/0.3 = 1/3
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(d) Show (in general) how you can dominate any portfolio combining asset X and the
risk-free asset using a portfolio that combines asset Z and the risk-free asset.
Hint: by “general”, I mean you assume any general fraction (like y X) of wealth in asset
X. And then show how to design a portfolio combining asset Z (with the fraction y Z of
wealth in asset Z) and the risk-free asset which will dominate the portfolio of asset X
and the risk-free rate. So essentially you will need to show the relationship between y Z
of the DOMINATING portfolio and yX of the DOMINATED portfolio.
�[��X] = �� × �� = �� × 0.2
[�Z] = � × � = � × 0.3
If [�X][= [�Z] , we get �� = 2/3 �
[E[�X] = �� + ��(E[��] – ��) = 0.04 + �� × (0.07 – 0.04) = 0.03 � + 0.04
[E[�Z] = �� + ��(E[�Z] – ��) = 0.04 + �Z × (0.16 – 0.04) = 0.08 �� + 0.04
When [�X][= [�Z] , E
[ [�Z] > E
[ [�X].
PCZ dominates PCX.
Q2 (Essential to cover – a, b, c, d)
Suppose that the risk-free rate is 3% and that the corresponding optimal risky portfolio
has an expected return of 15% and a standard deviation of 20%. Consider an investor
with preferences represented by the utility function U = E(r) – 0.5Aσ2, where A = 2.
(a) What fraction of her wealth should she invest in the risky portfolio?
This means the investor should borrow 50% of her wealth and then invest the total
amount
of money she has, 150% of her wealth, in the optimal risky portfolio P*.
(b) Should she invest more or less fraction of her wealth in the optimal risky portfolio if
she is more risk-averse? Why?
y*is decreasing in A, meaning that a more risk-averse investor (i.e. with a higher A)
should invest less in P*.
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(c) Should she invest more or less fraction of her wealth in the optimal risky portfolio if
the optimal risky portfolio offers a higher expected return (but the same standard
deviation)? Why?
y*is increasing in E(rp*), meaning that the more rewards in terms of E(r) we get for
taking the same risk, the more we invest in the risky portfolio P*.
(d) If the risk-free rate is higher, what would you expect the optimal risky portfolio to
differ from the current one (for 3% risk-free rate) in terms of expected return and
standard deviation?
The optimal risky portfolio is the tangent portfolio of the linear line from rf to the
efficient frontier. As the rf increase, the tangent curve will be flatter, so the new P*
should have a higher expected return and a higher volatility.
(e) Now suppose that the investor faces a higher risk-free rate when borrowing (because
you are facing more borrowing constraints than the government, or people won’t allow
you to borrow at the same rate as the government). Specifically, the investor may lend
at a risk-free rate of 3% but has to borrow at a risk-free rate of 5%. Assume for
simplicity that the optimal risky portfolio is the same for either 3% risk-free rate or 5%
risk-free rate, i.e., with an expected return of 15% and a standard deviation of 20%
(this should not be the case in reality, as you will find out in question (d)). What
fraction of her wealth should the investor now put in the risky portfolio?
The key here is: you would need to understand what weights in the optimal risky
portfolio mean she will lend, and what weights mean she will borrow.
If y* ≤ 1, .
If y* > 1, , this is doable.
Hence, the optimal portfolio is to borrow 25% of her wealth at rf = 5% and invest
125% of her wealth in the optimal risky portfolio.
(f) What is the expected return and standard deviation of the portfolio that you found in
(e)?
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