Chapter 06 - Efficient Diversification

CHAPTER 06
EFFICIENT DIVERSIFICATION
5. Impact on total variance

a. Both will have the same impact. The total variance will increase from .1714 to .
1921
b. An increase in beta, however, increases the correlation coefficient and thus
creates more diversification benefit.
8. The parameters of the opportunity set are:
E(rS) = 18%, E(rB) = 9%, S = 38%, B = 32%, = 0.13, rf = 4.8%
From the standard deviations and the correlation coefficient we generate the covariance
matrix [note that Cov(rS, rB) = SB]:
Bonds
Stocks

Bonds
1024.0
158

Stocks
158
1444

The minimum-variance portfolio proportions are:

w Min (S)

2B Cov(rS , rB )
S2 2B 2Cov(rS , rB )
1024 158
0.4024
1444 1024 ( 2 158)

wMin(B) = 0.5976
The mean and standard deviation of the minimum variance portfolio are:
E(rMin) = (0.4024 18%) + (0.5976 9%) 12.62%

Min w S2 S2 w 2B 2B 2w S w B Cov(rS , rB )

= [(0.4024 2 1444) + (0.59762 1024) + (2 0.4024 0.5976 158)]1/2

= 25.99%

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Chapter 06 - Efficient Diversification

% in stocks

% in bonds

Exp. return

Std dev.

9.00
00.00
100.00
23.00*
20.00
80.00
10.20
20.37*
40.24
59.76
12.62
25.99
Minimum variance
40.00
60.00
11.40
20.18*
60.00
40.00
12.60
22.50*
76.36
23.64
15.87
30.92
Tangency portfolio
80.00
20.00
13.80
26.68*
100.00
00.00
15.00
32.00*
*except for the minimum variance and the tangency portfolio, the yellow highlighted
answer are wrong, they were based on previous version.

9.

The graph approximates the points:

E(r)
12.62%
15.87%

Minimum Variance Portfolio

Tangency Portfolio

25.99%
30.92%

10. The reward-to-variability ratio of the optimal CAL is:

E ( rp ) r f

15.87 4.8
0.3581
30.92

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Chapter 06 - Efficient Diversification

11.
a. The equation for the CAL is:
E (rC ) r f

E (rp ) r f

C 4.8 0.3581 C

Setting E(rC) equal to 15% yields a standard deviation of: 28.49%

b. The mean of the complete portfolio as a function of the proportion invested in
the risky portfolio (y) is:
E(rC) = (l y)rf + yE(rP)
= (rf - yrf) + yE(rP)
= rf + y[E(rP) rf]
= 4.8 + y(15.87 4.8)
= 4.8 + 11.07y
Or
y = [E(rC) 4.8]/11.07
Setting E(rC) = 15%
y = [15 4.8]/11.07
= 0.9212 (92.12% in the risky portfolio)
1 y = 0.0788 (7.88% in T-bills)
From the composition of the optimal risky portfolio:
Proportion of stocks in complete portfolio = 0.9212 0.7637 = 0.7035
Proportion of bonds in complete portfolio = 0. 9212 0.2363 = 0.2177
19. The probability distribution is:
Probability
0.62
0.38

Rate of Return
100%
-50%

Expected return = (0.62 100%) + 0.38 (50%) = 43%

Variance = [0.62 (100 43)2] + [0.38 (50 43)2] = 5301
Standard deviation = 5301 = 72.81%
20. The expected rate of return on the stock will change by beta times the unanticipated
change in the market return: 1.3 (9% 10.5%) = 2.0%
Therefore, the expected rate of return on the stock should be revised to:
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Chapter 06 - Efficient Diversification

13.65% 2.0% = 11.65%

21.
a. The risk of the diversified portfolio consists primarily of systematic risk. Beta
measures systematic risk, which is the slope of the security characteristic line (SCL).
The two figures depict the stocks' SCLs. Stock B's SCL is steeper, and hence Stock
B's systematic risk is greater. The slope of the SCL, and hence the systematic risk,
of Stock A is lower. Thus, for this investor, stock B is the riskiest.
b. The undiversified investor is exposed primarily to firm-specific risk. Stock A
has higher firm-specific risk because the deviations of the observations from the
SCL are larger for Stock A than for Stock B. Deviations are measured by the
vertical distance of each observation from the SCL. Stock A is therefore riskiest
to this investor.

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