MIT Sloan School of Management

Finance Theory I Scott Joslin 15.401 CD Spring 2008

Problem Set 4
(Due: 5pm, Wednesday, April 16, 2008) 1. Which statements about portfolio choice are correct? (a) Diversication reduces the portfolios expected return because it reduces the portfolios total risk. (b) As more securities are added to a portfolio, total risk would typically be expected to fall at a decreasing rate. (c) A stock with high standard deviation may contribute less to portfolio risk than a stock with a lower standard deviation. 2. There are only two securities (A and B, no risk free asset) in the market. Expected returns and standard deviations are as follows: Security Stock A Stock B Expected return 25% 15% standard Deviation 20% 25%

(a) The correlation between stocks A and B is 0.8. Compute the expected return and standard deviation of a portfolio that has 0% of A, 10% of A, 20% of A, etc, until 100% of A. Plot the portfolio frontier formed by these portfolios. (b) Repeat the previous question, assuming that the correlation is 0.2. (c) Explain intuitively why the portfolio frontier is dierent in the two cases. 3. For this problem assume that it is possible to borrow and lend risklessly at a rate of 4%. Also assume that the expected return on the tangency (i.e., the optimal) portfolio composed only of risky assets is 13% with a standard deviation of 18%. Below we list 6 pairs of expected return and standard deviation combinations. For each pair determine whether the pair is feasible or not feasible. A portfolio is feasible if there is at least one investment that can be made using risky assets and riskless borrowing or lending that produces this level of expected return and standard deviation. Then, if the pair is feasible, determine whether it is ecient or not. It is ecient if the expected return is the highest level that can be obtained for the associated level of standard deviation. Pair a b c d e f Standard Deviation 20.00% 12.00% 30.00% 60.00% 2.00% 45.00% 1 Expected Return 24.75% 18.00% 19.00% 50.00% 1.00% 56.50%

4. Portfolio Manager for A Day You have just been hired as a portfolio manager at 15401 Asset Management, and you are given $1 million dollars to invest. Your analysts have provided you with a list of recommended stocks: Microsoft (A), GE (B) and Exxon (C). Your job is to gure out how to invest the money in these stocks. Here are the instructions on how to get the necessary data: 1. Go to Yahoo Finance and download the monthly prices from January 1997 to March 2008. 2. Using the historical prices, compute the monthly returns for these stocks (monthly data gives us better estimates of variance and covariance than yearly data). You will now use the returns from January 1997 to December 2007 (not 2008) to construct the portfolio frontier for the three stocks. (a) Calculate the sample mean and sample standard deviation of the historical monthly returns for the three companies. Use RET column which means return including dividends. You may nd the excel spreadsheet functions average and stdev useful for this. Also calculate the sample correlation matrix for the monthly returns of the three companies. You may nd the Excel spreadsheet function correl useful for this. For this problem, you must express the sample means, standard deviations, and correlations accurate to 5 decimal places. (b) Use the sample means, standard deviations, and correlation matrix that you calculated in part (a) to calculate the sample mean and sample standard deviation of a portfolio that is (i) equally weighted in each of the three stocks, and (ii) weighted according to the ratio 3:2:1 in A, B, C respectively. You answers must be accurate to 5 decimal places. (c) Again, using the sample means, standard deviations, and correlation matrix that you calculated in part (a), ll in the entries in the table below. The reported standard deviation and portfolio weights in a given row should be that of the frontier portfolio corresponding to the given mean. You can use Solver in Excel to solve for these portfolio weights. Mean 2.2% 2.0% 1.8% 1.6% 1.4% 1.2% 1.0% standard deviation weight A weight B weight C

(d) Plot the portfolio frontier using the entries in the preceding table. Plot each of the individual companies inside the feasible set. Comment on the weights of the portfolios along the portfolio frontier, making sure that you include some discussion of the correlation among the 3 companies. (e) Now lets run a horse race. You have decided to invest all the money in the portfolio on the frontier that gives average monthly return of 2.0%. Suppose you make the investment based on these weights on January 1, 2008. How much is the return from January to March 2008 for this frontier portfolio? How much will be the return had you invested in an equal-weighted portfolio of the 3 stocks? (f) Suppose there is a riskless asset that has a monthly return of 0.5%. Plot the resulting portfolio frontier and identify the tangent portfolio.