ASB-3207

Financial Economics

Mohammed Marzooq
ID: 500256943

Answer 1
Expected return

E(RA) = 0.05

Standard Deviation
0.4

(RA) = 0.25

a) Where P (RA, RB) = 0

For the first set, the portfolio weights are:
(A, B) = (1.5, -0.5)
E(Rp) = A x E(RA) + B x E(RB)
E(Rp) = (1.5 x 0.05) + (-0.5 x 0.1) = 0.025
(Rp) = ( A2 x 2(RA) + B2 x 2(RB) )
(Rp) = ( (2.25 x 0.0625) + (0.25 x 0.16) )
(Rp) = (0.180625)
(0.180625) = 0.425

For the second set, the portfolio weights are:

(A, B) = (1, 0)
E(Rp) = A x E(RA) + B x E(RB)
E(Rp) = (1 x 0.05) + (0 x 0.1) = 0.05
(Rp) = ( A2 x 2(RA) + B2 x 2(RB) )
(Rp) = ( (1 x 0.0625) + (0 x 0.16) )
(Rp) = (0.0625)
(0.0625) = 0.25

For the third set, the portfolio weights are:

(A, B) = (0.5, 0.5)
E(Rp) = A x E(RA) + B x E(RB)
E(Rp) = (0.5 x 0.05) + (0.5 x 0.1) = 0.075

E(RB) = 0.1
(RB) =

ASB-3207
Financial Economics
(Rp) = ( A2 x 2(RA) + B2 x 2(RB) )
(Rp) = ( (0.25 x 0.0625) + (0.25 x 0.16) )
(Rp) = (0.055625)
(0.11125) = 0.23585

For the fourth set, the portfolio weights are:

(A, B) = (0, 1)
E(Rp) = A x E(RA) + B x E(RB)
E(Rp) = (0 x 0.05) + (1 x 0.1) = 0.1
(Rp) = ( A2 x 2(RA) + B2 x 2(RB) )
(Rp) = ( (0 x 0.0625) + (1 x 0.16) )
(Rp) = (0.16)
(0.12875) = 0.4

For the fifth set, the portfolio weights are:

(A, B) = (-0.5, 1.5)
E(Rp) = A x E(RA) + B x E(RB)
E(Rp) = (-0.5 x 0.05) + (1.5 x 0.1) = 0.125
(Rp) = ( A2 x 2(RA) + B2 x 2(RB) )
(Rp) = ( (0.25 x 0.0625) + (2.25 x 0.16) )
(Rp) = (0.375625)
(0.0625) = 0.61288

b) Where P (RA, RB) = 0

VAR (Rp) = A2 x 2(RA) + B2 x 2(RB)
A + B = 1 B = 1 - A
VAR (Rp) = (A2 x 0.252) + (B2 x 0.42)
VAR (Rp) = (A2 x 0.0625) + (B2 x 0.16)

Mohammed Marzooq
ID: 500256943

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

VAR (Rp) = (A2 x 0.0625) + ( (1 - A)2 x 0.16 )

VAR (Rp) = 0.0625A2 + 0.16 0.32A + 0.16A2
VAR (Rp) = 0.2225A2 0.32A + 0.16
= 0.445A -0.32
A = 0.32/0.445 = 0.719
B = 1 0.719 = 0.281
Assuming the minimum attainable variance is where, P (RA, RB) = 0
VAR (Rp) = A2 x 2(RA) + B2 x 2(RB)
VAR (Rp) = (0.7192 x 0.0625) + (0.2812 x 0.16)
VAR (Rp) = 0.03231 + 0.01263
VAR (Rp) = 0.04494 = = 0.21199

c) Where P (RA, RB) = 0.5

For the first set, the portfolio weights are:
(A, B) = (1.5, -0.5)

E(Rp) = 0.025

(Rp) = (A2 x 2(RA)) + (B2 x 2(RB)) + (2 x A x B x P (RA, RB) x

(RA) x (RB))
(Rp) = (2.25 x 0.0625) + (0.25 x 0.16) + (2 x 1.5 x -0.5 x 0.5 x
0.25 x 0.4)
(Rp) = (0.14063) + (0.04) + (-0.075)
(Rp) = (0.10563)
(0.10563)= 0.32501

For the second set, the portfolio weights are:

(A, B) = (1, 0)

E(Rp) = 0.05

(Rp) = (A2 x 2(RA)) + (B2 x 2(RB)) + (2 x A x B x P (RA, RB) x

(RA) x (RB))
(Rp) = (1 x 0.0625) + (0 x 0.16) + (2 x 1 x 0 x 0.5 x 0.25 x 0.4)
(Rp) = (0.0625)

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

(0.0625) = 0.25

For the third set, the portfolio weights are:

(A, B) = (0.5, 0.5)

E(Rp) = 0.075

(Rp) = (A2 x 2(RA)) + (B2 x 2(RB)) + (2 x A x B x P (RA, RB) x

(RA) x (RB))
(Rp) = (0.25 x 0.0625) + (0.25 x 0.16) + (2 x 0.5 x 0.5 x 0.5 x
0.25 x 0.4)
(Rp) = (0.01563) + (0.04) + (0.025)
(Rp) = (0.08063)
(0.08063) = 0.28395

For the fourth set, the portfolio weights are:

(A, B) = (0, 1)

E(Rp) = 0.1

(Rp) = (A2 x 2(RA)) + (B2 x 2(RB)) + (2 x A x B x P (RA, RB) x

(RA) x (RB))
(Rp) = (0 x 0.0625) + (1 x 0.16) + (2 x 0 x 1 x 0.5 x 0.25 x 0.4)
(Rp) = (0.16)
(0.16) = 0.4

For the fifth set, the portfolio weights are:

(A, B) = (-0.5, 1.5)

E(Rp) = 0.125

(Rp) = (A2 x 2(RA)) + (B2 x 2(RB)) + (2 x A x B x P (RA, RB) x

(RA) x (RB))
(Rp) = (0.25 x 0.0625) + (2.25 x 0.16) + (2 x -0.5 x 1.5 x 0.5 x
0.25 x 0.4)
(Rp) = (0.01563) + (0.36) + (-0.075)
(Rp) = (0.30063)
(0.30063) = 0.54829

Where P (RA, RB) = 0.5

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

VAR (Rp) = A2 x 2(RA) + B2 x 2(RB) + (2 x A x B x P (RA, RB) x (RA)

x (RB))
VAR (Rp) = (A2 x 0.252)+ (B2 x 0.42) + (2 x A x B x 0.5 x 0.25 x 0.4)
A + B = 1 B = 1 - A
VAR (Rp) = (A2 x 0.252) + ((1-A)2 x 0.42) + (2 x A x (1-A) x 0.5 x
0.25 x 0.4)
VAR (Rp) = 0.2225A2 0.32A + 0.16+ 0.1A 0.1A2
VAR (Rp) = 0.1225A2 0.22A + 0.16
= 0.245A 0.22
A = 0.22/0.245 = 0.89796
B = 1 0.89796 = 0.10204

Assuming the minimum attainable variance is where, P (RA, RB) =

0.5
VAR (Rp) = A2 x 2(RA) + B2 x 2(RB) + 2 x A x B x Cov
Cov = Corr x (RA) x (RB)
Cov = 0.5 x 0.25 x 0.4 = 0.05
VAR (Rp) = (0.897962 x 0.252) + (0.102042 x 0.42) + (2 x 0.89796 x
0.10204 x 0.05)
Where P(RA, RB) = 0

E(Rp)

(Rp)
0.025
0.05
0.075
0.1
0.125

0.425
0.25
0.23585
0.4
0.61288

VAR (Rp) = 0.0504 +

0.00167+ 0.00916
VAR (Rp) = 0.06123
VAR (Rp) = 0.06123 =
= 0.46357

Where P(RA, RB) = 0.5

E(Rp)
0.025
0.05
0.075
0.1
0.125

(Rp)
0.32501
0.25
0.28395
0.4
0.54829

d)

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

0.7
0.6
0.5
0.4

P(RA, RB) = 0

0.3

P(RA, RB) = 0.5

0.2
0.1
0
0

0.02 0.04 0.06 0.08

0.1

0.12 0.14

e) The correlation observed between the two securities implies great

influences on gains relative to the reduction in risk. The two
portfolios demonstrate a combination of differing securities that are
long positioned with a positive correlation coefficient, which in turn
leads to a build up in the risk factor. This is normally a result of the
returns on one security and another both decrease. In the third set,
the portfolio weights (A, B) can be observed at (0.5, 0.5). This
means that the securities of the portfolio have an equal weightage,
the standard deviation is equal to 23.585%. In this scenario, there is
no correlation between the securities (correlation = 0). An increase
in the correlation coefficient to 0.5 would increase the standard
deviation to a value of 28.395%.
The second security (security B) has a short selling since (B) is
equal to -0.5. When both securities have 0 correlation between
them, the resulting standard deviation is 42.5%. As demonstrated
previously, if the correlation coefficient were at a value of 0.5, the
standard deviation would consequently decrease to 40%. It is
important to note that in scenarios of short selling, it is more
acceptable to have low returns, rather than high ones.
When P (RA, RB) = 0.5, the correlation is positive. Security A and
Security Bs returns demonstrate a decrease in this area. If investors
own both securities A and B, they will benefit from increases in A
and suffer from decreases in B. If investors merge short and long
term positions in the portfolio where securities have a positive

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

correlation, they would benefit due to the risk reduction that results
from maintaining a diversified portfolio.
Answer 2
a)

E(RM) = 0.1

(RM) = 0.5

Correlation Coefficient P(RA, RM) = 0.2

Standard Deviation

(RA) = 0.3

RF = 0.04
P(RB, RM) = 0.4
(RB) =

0.7
i) For Security A,
i = Cov (RI, RM) / Var (RM)
A = (0.2 x 0.3 x 0.5) / (0.52)
0.03/0.25 = 0.12
ii) For Security B,
i = Cov (RI, RM) / Var (RM)
B = (0.4 x 0.7 x 0.5) / (0.52)
0.14/0.25 = 0.56

b) E(RI) = RF + i [E(RM) RF]

For Security A,
E(RA) = 0.04 + 0.12 (0.1 0.04)
E(RA) = 0.04 + 0.0072
E(RA) = 0.0472
For Security B,
E(RB) = 0.04 + 0.56 (0.1 0.04)
E(RB) = 0.04 + 0.0336
E(RB) = 0.0736

c) The Security Market Line is used to demonstrate the risk between

a security and its expected rate.
Security Market Line,
E(RI) = RF + i [E(RM) RF]
Low
Risk

ASB-3207
Financial Economics
For Security A,

i = 0.12

For Security B,

i = 0.56

Mohammed Marzooq
ID: 500256943

The security Market line which can be seen above demonstrates

that there is a linear relationship between a securitys beta value
and its expected return.
It can be surmised that the two securities (A and B) each have a
various expected return from a particular level of risk. In terms of
Security A, the expected return was 4.72% and the beta was 0.12.
Security B had expected returns of 7.36% and a beta value of 0.56.
As the graph demonstrates, the agreed upon convention is that the
risk free assets beta factor assumes a value of 0, whilst the overall
beta value for all securities (market) is equal to 1.
d)
i) For Security A
E(RA) = RF + A [E(RM) RF]
When the equation is rearranged, we get:
E(RA) = (1 - A) x RF + A x E(RM)
E(RA) = + A x RM + At

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

A = RF (1 - A)
RAt = A + A + RM + At
A is the intercept of the characteristic line for Security A, At is the
error for Security A.
ii) For Security B
RBt = B + B x RMt + Bt
B = RF (1 B)

The characteristic line for Securities A and B demonstrate the

relationship between the returns and the market portfolio. When
the rate of return in the market portfolio is equal to 10%, Security A
is expected to incur a 4.7% profit. In terms of Security B, a 10% rate
of return within the market yields an expected return of 7.36%.

Answer 3
a) For Security A,
E(RI) = RF + I [E(RM) RF]
0.06 = 0.05 + A (0.1 0.05)
A (0.1 0.05) = 0.06 0.05
0.05 A = 0.01
A = 0.01/0.05
A = 0.2

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

For Security B,
E(RI) = RF + I [E(RM) RF]
0.08 = 0.05 + B (0.1 0.05)
B (0.1 0.05) = 0.08 0.05
0.05 B = 0.03
B = 0.03/0.05
B = 0.6
For Security C,
E(RI) = RF + I [E(RM) RF]
0.08 = 0.05 + C (0.1 0.05)
C (0.1 0.05) = 0.08 0.05
0.05 C = 0.03
C = 0.03/0.05
C = 1.2

b) For Security A,
(RA) = 0.7

2 (RA) = 0.49

0.49 = (0.22 x 0.52) + 2 (A)

0.49 = 0.01 + 2 (A)
2 (A) = 0.49 0.01
2 (A) = 0.48
For Security B,
(RA) = 0.6

2 (RA) = 0.36

0.36 = (0.62 x 0.52) + 2 (A)

0.36 = 0.09 + 2 (A)
2 (A) = 0.36 0.09
2 (A) = 0.27 ----> Unsystematic Risk
For Security C,
(RA) = 0.8

2 (RA) = 0.64

ASB-3207
Financial Economics

Mohammed Marzooq
ID: 500256943

0.64 = (1.22 x 0.52) + 2 (A)

0.64 = 0.36 + 2 (A)
2 (A) = 0.64 0.36
2 (A) = 0.28 ----> Unsystematic Risk
c) Security Cs higher standard deviation value of 0.8 does not
necessarily make it a riskier security than Security A whose
standard deviation value is 0.7. In these situations, it is important to
maintain the underlying purpose of the Capital Asset Pricing Model,
which tests for risk rather than standard deviation. It is important to
look into the value of Securities A and B which are 0.2 and 0.6
respectively, since they are more indicative of the CAPM
requirements. Simply put, even when the standard deviation of a
security is higher than that of another, it does not necessarily mean
that one bears a greater risk than the other.

d) E(Rp) = A x E(RA) + B x E(RB) + C x E(RC)

A = 30/100 = 0.3

B = 40/100 = 0.4

C = 30/100 = 0.3

E(Rp) = (0.3 x 0.06) + (0.4 x 0.08) + (0.3 x 0.11)

E(Rp) = 0.018 + 0.032 + 0.033
E(Rp) = 0.083 or 8.3%

e) E(Rp) = RF + P [E(RM) RF]

E(Rp) = 0.083

RF = 0.05

0.083 = 0.05 + P (0.1 0.05)

0.05 P = 0.083 0.05
P = 0.033/0.05
P = 0.66

f) P =0.3 A + 0.4 B + 0.3 C

P = (0.3 x 0.2) + (0.4 x 0.6) + (0.3 x 1.2)
P = 0.06 + 0.24 + 0.36
P = 0.66

E(RM) = 0.1