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1. Which of the following choices best completes the following statement? Explain. An investor
with a higher degree of risk aversion, compared to one with a lower degree, will prefer
investment portfolios
(e) None of the above is true.
The answer is not (d) with a higher Sharpe ratio because: The way the question is phrased, the
high-risk-aversion investor will prefer the high Sharpe ratio investment as will the low-risk-aversion
investor. You cant say the high-risk-aversion investor would not prefer it more.
The way I read the question at first was that the high-risk-aversion investor will have the risk-free
and the high Sharpe ratio investment on their indifference curve. The low-risk-aversion investor will
have some lower Sharpe ratio investment in their indifference curve. Therefore the high-riskaversion investor will prefer the investment with the high Sharpe ratio.
But that is not what the question says. Since both investors would prefer the high Sharpe ratio
investment, the high-risk-aversion investor would not prefer it more compared to the low-riskaversion investor. They would both prefer it. And you cant determine which would prefer it more.
5. 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 bills?
Utility for T-bills is: U = E(r) 0.5A2 = 0.07 - 0.5A(0)2 = 0.07
Utility for the portfolio: U = E(r) 0.5A2 = 0.12 - 0.5A(0.18)2
For what risk aversion level (A) would an investor be indifferent?
Set the Utility values equal and solve for A:
0.12 0.0162A = 0.07 A = 0.05/0.0162 = 3.09
For A = 3.09, the investor would be indifferent between the risky portfolio with E(r) = 12% and =
18% and the risk-free rate of 7%.
More risk aversion (A > 3.09) means an investor would derive less utility from the risky portfolio.
(Compute the utility for the risky portfolio if A = 3.5.)
Less risk aversion (A < 3.09) means an investor would derive more utility from the risky portfolio.
(Compute the utility for the risky portfolio if A = 2.5.)
Therefore the risk-aversion parameter (A) must be less than 3.09 for the risky portfolio to be
preferred to T-Bills.
6. Draw the indifference curve in the expected returnstandard deviation plane corresponding to
a utility level of .05 for an investor with a risk aversion coefficient of 3.
(Hint: Choose several possible standard deviations, ranging from 0 to .25, and find the
expected rates of return providing a utility level of .05. Then plot the expected returnstandard
deviation points so derived.)
U = E(r) 0.5A2 E(r) = 0.5A2 + U
Set U = 0.05 and A = 3 and use Excel to compute E(r) for values of between 0 and 0.25:
Table and chart for questions 6 through 9 below.
7. Now draw the indifference curve corresponding to a utility level of .05 for an investor with risk
aversion coefficient A = 4.
Table and chart for questions 6 through 9 below.
8. Draw an indifference curve for a risk-neutral investor providing utility level .05.
Risk neutral means A = 0.
Table and chart for questions 6 through 9 below.
9. What must be true about the sign of the risk aversion coefficient, A, for a risk lover? Draw the
indifference curve for a utility level of .05 for a risk lover
Risk lover means A < 0. In this case A = -3.
U = E(r) 0.5A2 E(r) = 0.5A2 + U (for a constant U)
Set U = 0.05 and use Excel to compute values of E(r) for the different values of A for from 0.00 to
0.25.
0.00%
5.00%
10.00%
15.00%
20.00%
25.00%
Question 6
3.00 = A
5.00%
5.38%
6.50%
8.38%
11.00%
14.38%
Question 7
4.00 = A
5.00%
5.50%
7.00%
9.50%
13.00%
17.50%
Question 8
0.00 = A
5.00%
5.00%
5.00%
5.00%
5.00%
5.00%
Question 9
-3.00 = A
5.00%
4.63%
3.50%
1.63%
-1.00%
-4.38%
Highlight the table in Excel and insert Scatter Chart. See Below.
20.00%
15.00%
E(r)
10.00%
5.00%
0.00%
0.00%
-5.00%
-10.00%
5.00%
10.00%
15.00%
3.00 = A
4.00 = A
0.00 = A
-3.00 = A
20.00%
25.00%
Note that the greater the value of A, the more return required for a given level of risk for the investor
to be indifferent between a risky asset and the risk-free. In other words, the red line for A = 4 is
above the blue line for A = 3. The more risk adverse investor (A = 4) requires more return for an
given level of risk.
Hint: Another way to produce this chart is it to type the following into Wolfram Alpha:
plot y=(3)(.5)x^2 + .05 and y=(4)(.5)x^2 + .05 and y=(0)(.5)x^2 + .05 and y=(-3)(.5)x^2 + .05 from
x = 0 to .25
10. For Problems 10 through 12 : Consider historical data showing that the average annual rate of
return on the S&P 500 portfolio over the past 80 years has averaged roughly 8% more than the
Treasury bill return and that the S&P 500 standard deviation has been about 20% per year.
Assume these values are representative of investors' expectations for future performance and
that the current T-bill rate is 5%.
Calculate the expected return, standard deviation and variance of portfolios invested in T-bills
and the S&P 500 index with T-Bill weights from 0.0 to 1.0 in 0.2 increments.
(Hint: T-Bills earn 5% and the S&P500 earns 8.00% more so E(rS&P500) = 5% + 8% = 13%)
Answer for 10 through 12 in the table below:
11. Calculate the utility levels of each portfolio of Problems 10 for an investor with A = 2. What do
you conclude?
Answer for 10 through 12 in the table below:
3
1 y = WT-Bills
0.0
0.2
0.4
0.6
0.8
1.0
E(rC)
13.00%
11.40%
9.80%
8.20%
6.60%
5.00%
C
20.00%
16.00%
12.00%
8.00%
4.00%
0.00%
2C
0.0400
0.0256
0.0144
0.0064
0.0016
0.0000
U for A = 2.0
0.0900
0.0884
0.0836
0.0756
0.0644
0.0500
U for A = 3.0
0.0700
0.0756
0.0764
0.0724
0.0636
0.0500
For the lower risk aversion (A = 2), Utility is maximized with 100% in the S&P500.
For the higher risk aversion (A = 3), Utility is maximized with 40% in T-Bills and 60% in the
S&P500.
Extra Questions:
Solve for the Utility maximizing allocation between the risky portfolio and T-bills for each level of
risk aversion. Then solve for the E(rC)* and C* and the U* for these optimal portfolios.
A = 2.0:
y* = [E(rP) rf]/A2P = (0.13 0.05)/[2.00(0.20)^2] = 1.00
E(rC)* = rf + y*[E(rP) rf] = 0.05 + 1.00[0.13 0.05] = 13.00%
C* = y*P = 1.00(0.20) = 20.00%
U* = E(rC*) A(0.5)(C*)2 = 0.13 (2)(0.5)(0.2)2 = 0.0900
A = 3.0:
y* = [E(rP) rf]/A2P = (0.13 0.05)/[2.00(0.20)^2] = 1.00
E(rC)* = rf + y*[E(rP) rf] = 0.05 + 0.67[0.13 0.05] = 10.33%
C* = y*P = 0.67(0.20) = 13.33%
U* = E(rC*) A(0.5)(C*)2 = 0.13 (2)(0.5)(0.2)2 = 0.0900
Note that U* = 0.0767 for the 67-33 portfolio exceeds U = 0.0764 for the 60-40 portfolio in the
table above.
Use these inputs for Problems 13 through 19: You manage a risky portfolio with expected rate of
return of 18% and standard deviation of 28%. The T-bill rate is 8%
13. Your client chooses to invest 70% of a combined portfolio in your risky portfolio (E(rP) =
18.00% and P = 28.00%) and 30% in a T-Bill money market fund. What is the expected
return and standard deviation on the clients combined portfolio?
The clients 70-30 Combined Portfolio:
4
25%
32%
43%
100%
of 70%
of 70%
of 70%
= 18%
= 22%
= 30%
70%
15. What is the reward-to-volatility ratio (S) of your risky portfolio (P) and your client's (70-30)
combined portfolio?
S = [E(r) - rf]/
Your Risky Portfolio: SP = [0.18 0.08]/0.28 = 0.3571
Clients Combined Portfolio: SC = [0.15 0.08]/0.196 = 0.3571
Note that both portfolios lay on the Capital Allocation Line (CAL) defined by rf = 8% and E(rP) =
18.00% and P = 28.00%.
The Slope of the CAL is 0.3571 at any point on the line.
16. Draw the CAL of your portfolio on an expected returnstandard deviation diagram. What is
the slope of the CAL? Show the position of your client on your fund's CAL.
E(rC) = rf + y[E(rP) rf]
C = yP
Substitute for y in E(rC) to get return as a function of risk for a given risk portfolio and risk-free:
In other words, we need E(rC) as a function of C for a given E(rP) and P:
C = yP y = C/P
E(rC) = rf + y[E(rP) rf] = rf + C/P [E(rP) rf] = rf + C [E(rP) rf]/P
The return of the combined portfolio (E(rC)) is a linear function of the risk of the combined portfolio
(C). The intercept (rf = 0.08) and the slope ([E(rP) rf]/P = 0.3571) are constants.
Produce this table in Excel:
C
0.00%
19.60%
28.00%
E(rC)
8.00%
15.00%
18.00%
20%
28.00%, 18.00%
18%
16%
14%
19.60%, 15.00%
E(rC)
12%
10%
8%
0.00%, 8.00%
6%
4%
2%
0%
0%
5%
10%
15%
20%
25%
30%
17. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall combined portfolio will have an expected rate of return
of 16%.
(a) What is the proportion in the risky portfolio (y)?
E(rC) = rf + y[E(rP) rf]
y = [E(rC) - rf]/[E(rP) rf]
y = [0.16 0.08]/[0.18 0.08] = 0.80
80% in the risky, 20% in the risk-free
(b) What are your client's investment proportions in your three stocks and the T-bill fund?
Stock A =
Stock B =
Stock C =
25%
32%
43%
100%
of 80%
of 80%
of 80%
= 20%
= 26%
= 34%
80%
(c) What is the standard deviation of the rate of return on your client's portfolio?
C = yP = 0.80(0.28) = 22.4%
18. Suppose that your client prefers to invest in your risky fund a proportion y that maximizes the
expected return on the combined portfolio subject to the constraint that the combined
portfolio's standard deviation (C) will not exceed 18%.
(a) What proportion of the combined portfolio will be invested in the risky portfolio (y)?
C = yP y = C/P = 0.18/0.28 = 64.29%
(b) What is the expected return on the combined portfolio?
E(rC) = rf + y[E(rP) rf] = 0.08 + (0.6429)(0.18 0.08) = 14.43%
19. Your client's degree of risk aversion is A = 3.5.
(a) What proportion of the combined portfolio will be invested in the risky portfolio (y) in
order to maximize utility?
y* = [E(rP) rf]/A2P = (0.18 0.08)/[3.5(0.28) 2] = 36.44%
(b) What is the expected return and standard deviation of the return on your client's optimized
portfolio?
E(rC)* = rf + y*[E(rP) rf] = 0.08 + 0.3644[0.18 0.08] = 11.64%
C* = y*P = 0.3644(0.28) = 10.20%
Extra Question:
Calculate your clients utility for y = 1, y = 0.70, y = 0.80. y = 0.6429 and y* = 0.3644 given a riskaversion level of 3.5.
U* = E(rC*) A(0.5)(C*)2
y = WP
100.00%
80.00%
1 -y = WT-Bills
0.00%
20.00%
E(rC)
18.00%
16.00%
C
28.00%
22.40%
U for A = 3.5
0.0428
0.0722
70.00%
64.29%
36.44%
0.00%
30.00%
35.71%
63.56%
100.00%
15.00%
14.43%
11.64%
8.00%
19.60%
18.00%
10.20%
0.00%
0.0828
0.0876
0.0982
0.0800
(a) If your risk-aversion coefficient is A = 4 and you believe that the entire 19262009 period is
representative of future expected performance, what fraction of your portfolio should be
allocated to T-bills and what fraction to equity?
A = 4, E(rM) rf = 7.93%, M = 20.81%
y* = [E(rP) rf]/A2P = (0.0793)/[4(0.2081) 2] = 45.78%
45.78% allocated to the S&P500 and 54.22% allocated to T-bills
Additional Questions:
1. Given the following states of the economy, the probabilities of the states and the returns for
assets 1 and 2 given the states, calculate the expected return and standard deviation for Asset
1, Asset 2, and a 40-60 portfolio of Asset 1 and 2. (Note that you need to calculate the
covariance between 1 and 2.)
State
Expansion
Contraction
Drought
W1 = 40%
ps
0.6
0.3
0.1
r1s
0.30
0.05
-0.20
r2s
0.10
0.10
-0.30
W2 = 60%
A=2
62.50%
37.50%
A=6
20.83%
79.17%
E(rC)
8.13%
6.04%
C
Certainty Equiv (U)
12.50%
6.56%
4.17%
5.52%
10
j) Compare the utility level of each investor at their optimal combined portfolio. Which investor
is better off?
THIS IS A TRICK QUESTION! You cant compare utility levels across individuals. Each investor
is at his or her optimum so each is as well off as they can be.
CFA PROBLEMS
1.
1
0.12
0.30
-0.0600
2
0.15
0.50
-0.3500
3
0.21
0.16
0.1588
4
0.24
0.21
0.1518
2.
When investors are risk neutral, then A = 0; the investment with the highest utility is Investment 4
because it has the highest expected return.
3.
(b)
4.
Indifference curve 2
5.
Point E
6.
7.
(b)
8.
Expected return for equity fund = T-bill rate + risk premium = 6% + 10% = 16%
Expected return of clients overall portfolio = (0.6 16%) + (0.4 6%) = 12%
Standard deviation of clients overall portfolio = 0.6 14% = 8.4%
9.
Reward-to-volatility ratio =
10
0.71
14
11