Economics 4400, Extra Problems on Risk

Problem 1.
Consider two stocks A, 1 with expected returns :
x
< :
y
and standard
deviations 0 < o
x
< o
y
.
a. Is it possible that a (A, 1 ) portfolio of with positive weights on both can
have expected return greater than :
y
? Smaller than :
x
?
b. Assume that j
x;y
, the correlation of their returns, is plus one. Is there
a portfolio of these two assets that has standard deviation smaller than o
x
?
Greater than o
y
?
c. Assume j
x;y
= 1. What is the lowest possible standard deviation of a
portfolio composed of A and 1 ?
d. Assume :
x
= 6%, :
y
= 10%, o
x
= 5%, o
y
= 10%, j
x;y
= 0. Is there
a portfolio of A , 1 with expected return 9%? If yes, what is the standard
deviation of that portfolio? Give an expression involving :
x
, :
y
.
Answer:
a. No, the return on a portfolio is weighted average of individual returns.
Unless you leverage yourself to buy 1 (that is, you buy 1 with revenue from
selling A), you cannot achieve larger return that the greater of the two.
b. No. When correlation is 1, standard deviation of a portfolio is the
weighted average of individual standard deviations (see pages 268-274). So
it has to lie in between them.
c. Zero. Check the variance of portfolio with weights n
x
=
y
x+y
, n
y
=
x
x+y
.
d. Solving c:
x
+(1 c):
y
= 9%, we get the weight: c =
3
4
. The standard
deviation is then
q
(
3
4
)
2
5%
2
+ (
1
4
)
2
10%
2
Problem 2.
Provide an example of three securities A, B, C such that:
a. A is positively correlated with B, B is positively correlated with C, and
A is positively correlated with C.
b. A is positively correlated with B, B is positively correlated with C, and
A is negatively correlated with C.
c. A is negatively correlated with B, B is positively correlated with C, and
A is positively correlated with C.
A prefered answer should be mathematical and specify number of states of
the world and each securitys return in each state. If you cannot be mathemat-
ical, give a real world example and explain the intuition behind it.
Answer.
a. This was the easy one. All returns in percents. You could have picked all
three assets giving identical returns in all states. Here is one possible example:
1 C
State 1 (probability 50%) 11 10 13
State 2 (probability 50%) 9 8 7
1
It should be obvious from the table that , 1, C are pairwise positively
correlated. All , 1, C take the high value in the same state, and there are only
two states.
b. Here is one possible example. Consider an economy with six equally
probable states. That is, the probability of each state is
1
6
. Assets , 1, C
percentage returns of assets are as in the table below.
1 C
State 1 11 11 10
State 2 9 9 10
State 3 10 11 11
State 4 10 9 9
State 5 11 10 9
State 6 9 10 11
It is easy to notice that is positively correlated with 1, as the only states
at which they are both dierent from their means are 1 and 2. Same with 1, C
- they only covary together in states 3, 4, and with , C, which move opposite
each other in 5, 6. For practice, you may compute correlations and covariances
with the formulas from class.
c. The question is identical to 3b, only the assets are relabelled.
Problem 3. Briey evaluate the following statements. True, False, Uncer-
tain? Why?
a. According to the CAPM model, it is possible that risky stocks command
lower expected return than risk-free bonds.
True. A risky stock may have negative covariance with the market, making
it more desirable than risk-free bonds for diversifying portfolios. Hence, it may
command lower expected return. Check out the CAPM formula with , < 0.
b. According to the CAPM model, all investors should hold the same port-
folio of risky stocks, regardless of their (that is, the investors) risk aversion.
True, in the sense that an investors degree of risk aversion only aects the
split of his/her portfolio between stocks and riskless bonds. Once you look at
stocks part of the portfolio, all investors should hold dierent risky stocks in
the same propotion.
c. According to the CAPM model, portfolios of all investors have the same
riskiness, even though investors have varying risk aversion.
No. Even though all investors choose the same mix of risky stocks, what
varies is portion of their portfolio thats put into riskless assets. The larger the
weight on bonds in a portfolio, the less risky it is.
d. Consider two stocks A, B. If investors are risk averse, the stock with
greater expected return must also be the one with the greater variance.
Not necessarily. According to CAPM model, the stock with greater expected
return must have greater beta. Greater beta is is not equivalent to greater
variance. Note that 5a is a special case of 5f.
g. When nancial markets are imperfect (that is, individuals cannot borrow
and lend at the same interest rate), investors may not necessarily rank projects
(cashow streams) according to the NPV rule.
2
True. The question is somewhat ambiguous. When lending rate =/= bor-
rowing rate *and you are patient*, you should still rank investment opportunities
according to NPV rule, discounting future cashows by the lending rate. Not
so, though, when you are impatient and need to consume (spend money) early.
An impatient person dislikes backloaded cashow streams and may opt for a
frontloaded project with low NPV. Back- vs-front loadedness does not matter
under perfect nancial markets, as an impatient person may always borrow $
for consumption in early periods and repay with future project cashows when
the borrowing rate is the same as the rate at which cashows are discounted.
Thats the essence of separation property (Chapter 4 in the textbook). Financial
markets being perfect is a key assumption there.
Problem 4. The diversication eect of a portfolio of two stocks
A) increases as the correlation between the stocks declines.
B) increases as the correlation between the stocks rises.
C) decreases as the correlation between the stocks rises.
D) both b and c.
E) None of the above.
Answer: A
Problem 5 A portfolio has 50% of its funds invested in Security One
and 50% of its funds invested in Security Two. Security One has a standard
deviation of 6. Security Two has a standard deviation of 12. The securities
have a coecient of correlation of .5. Which of the following values is closest to
portfolio variance?
A) 81.
B) 90.
C) 27.
D) 6561.
E) One must have covariance to calculate expected value.
Answer: A
Problem 6 A portfolio is entirely invested into Buzzs Bauxite Boring
Equity, which is expected to return 16%, and Zums Inc. bonds, which are
expected to return 8%. Sixty percent of the funds are invested in Buzzs and
the rest in Zums. What is the expected return on the portfolio?
A) 9.6%. B) 12.8%. C) 24%. D) 6.4%. E) Need additional infor-
mation.
Answer: B
3