1. Any security, even a pure-discount U.S.

government
security, presents its owner with an uncertain return if
the owner's holding period does not coincide with the
maturity of the security.
If the security's life is less than the owner's holding
period, then the owner faces the uncertainty associated
with not knowing at what interest rate the security's
proceeds can e reinvested when the security reaches
maturity. If the security's life is greater than the
owner's holding period, then the owner faces the
uncertainty associated with not knowing at what price the
security can e sold at the end of the holding period.
!. Interest rate risk involves the effect that interest rate
changes over the investor's holding period will have on
the market value of the security. If the investor's
holding period precedes the maturity date of the
security, then the investor will e uncertain as to what
price he or she will ultimately e ale to sell the
security.
"einvestment risk involves the effect that interest rate
changes will have on the return that the investor can
earn when he or she reinvests the proceeds from a
maturing security, if the investor's holding period is
longer than the life of the security.
#. $he standard deviation of a riskfree asset's return is
%ero y definition. $hat is, its return is certain.
$hus its return must e completely unrelated to the
returns on any other asset. $herefore, the covariance
etween a riskfree asset and a risky asset must e %ero.
&athematically'

ij
(
ij

i

j
and if the i
th
asset is the riskfree asset then
i
( ).
$hus'

ij
(
ij
)
j
( )
*. $he e+pected return of a portfolio invested in oth a
risky portfolio and a riskfree asset is given y'
r
p
( X
1 r
1
, X
!
r
f
-urther, ecause .X
1
, X
!
/ must e0ual 1.), then X
!
( .1 -
X
1
/.
a. r p ( .1.!) 112/ , .-.!) 12/
( 13.)2
. r
p ( ..4) 112/ , ..1) 12/
( 1*.)2
c. r p ( ..31 112/ , ..!1 12/
( 1!.12
1. $he e+pected return of a portfolio invested in oth a
risky portfolio and a riskfree asset is given y'
r
p
( X
1 r
1
, X
!
r
f
In this case, the e+pected return of the total portfolio
as well as the risky portfolio and riskfree asset are
known. $he 0uestion is what two weights, X
1
and X
!
will
solve the e0uation. $hat is'
!*2 ( .X
1
152/ , .X
!
12/
As .X
1
, X
!
/ must e0ual 1.), then X
!
( .1 - X
1
/, so'
!*2 ( .X
1
152/ , 6.1 - X
1
/ 127
Solving for X
1
yields a value of 1.*8, meaning that a
weighting of 1.*8 for the risky portfolio .thus involving
leverage/ and a weighting of -.*8 for the riskfree asset
will produce an e+pected return of !*2.
8. $he standard deviation of a portfolio composed of a risky
portfolio and a riskfree asset is given y'

p
( X
1

1
where X
1
is the weight of the risky portfolio and
1
is
the standard deviation of the risky portfolio. As X
1
(
.1 weight of the riskfree asset/, then'
a. X
1
( 1 ..#)/ ( 1.#), thus'

p
( 1.#) !)2
( !8.)2
. X
1
( 1 .1) ( .4), thus'

p
( .4) !)2
( 15.)2
c. X
1
( 1 .#) ( .3), thus'

p
( .3) !)2
( 1*.)2
3. $he standard deviation of a portfolio invested in a risky
portfolio and a riskfree asset is given y'

p
( X
1

1
As the standard deviation of 9yster's total portfolio is
!)2, solving for the proportion invested in the risky
portfolio .:
1
/ gives'
!)2 ( X
1
!12
X
1
( .5)
$he e+pected return of a portfolio invested in oth a
risky portfolio .with proportion X
1
/ and a riskfree asset
with proportion X
!
or .1 - X
1
/ is'
r p ( ..5) 1!2/ , 6.1 - .5)/ 327
( 11.)2
5. ;oth <ick and =atsy are correct. ;orrowing at the
riskfree rate to invest more than one's initial wealth in
a risky portfolio is e0uivalent to purchasing the risky
portfolio on margin. -urther, orrowing at the riskfree
rate is e0uivalent to taking a short position in the
riskfree asset and investing the proceeds of the short
sale in the risky portfolio.
4. $he efficient set ecomes all the portfolios that can e
constructed through a comination of a single risky
portfolio and lending or orrowing at the riskfree rate.
$he efficient set will therefore consist of all
portfolios along a ray emanating from the riskfree asset,
tangent to the curved &arkowit% efficient set .that is,
the efficient set without riskfree orrowing or lending/,
and continuing on out into risk-return space. $he
tangency point represents the optimal comination of
risky assets for the investor.
1). "iskfree orrowing and lending permits the investor to
create any comination of portfolios allocated etween a
risky portfolio .contained in the feasile set of risky
portfolios/ and the riskfree asset. $hese cominations
lie on rays emanating from the riskfree asset. $he more
a ray is tilted to the northwest, the more desirale is
the associated set of portfolios to the investor.
;ecause the feasile set of risky portfolios is concave,
the ray comining the riskfree asset and a risky
portfolio, tilted as far as possile to the northwest,
must e tangent to the feasile set of risky portfolios
at only one point. $his ray is the efficient set under
riskfree orrowing and lending.
All other portfolios in the feasile set of risky
portfolios .including the >old> efficient set/ will lie
to the south and?or east of this >new> efficient set and,
therefore, are dominated y the portfolios of the new
efficient set. $hat is, these other portfolios offer
less e+pected return and?or more risk than the portfolios
lying on the efficient set generated under riskfree
orrowing and lending.
11. Assuming that each investor has different opinions aout
the e+pected returns and standard deviations of
securities, and covariances etween securities, then they
will each face a different feasile set. As a result,
they will choose different risky portfolios.
As will e discussed in @hapter 1), if investors e+hiit
homogeneous e+pectations regarding e+pected returns and
risks, then they will all hold the same risky portfolio.
1!. $he feasile set now ecomes the area etween two rays,
each emanating from the riskfree asset. $he ray to the
northwest is the efficient set. $he ray to the southeast
will connect the riskfree asset and generally the lowest
e+pected return asset. Any comination of risk and
return etween these two rays can e created y
appropriately comining a risky portfolio with riskfree
orrowing or lending.
1#. $he efficient set will e the same for oth investors
ecause it represents investment opportunities, not
preferences. .9f course, the two investors may have
different e+pectations regarding availale e+pected
returns and risks./
$he more risk-averse investor's indifference curves will
e more steeply sloped than the indifference curves of
the less risk-averse investor.
$he optimal portfolio of the more risk-averse investor
will lie to the southwest of the less risk-averse
investor's optimal portfolio. ;oth optimal portfolios,
of course, will lie on the efficient set. $he more risk-
averse investor's optimal portfolio likely will lie to
the southwest of the tangency portfolio, implying lending
at the riskfree rate. @onversely, the less risk-averse
investor's optimal portfolio likely will lie to the
northeast of the tangency portfolio, implying orrowing
at the riskfree rate.
1*. a. $he riskfree asset has a %ero variance and has %ero
covariance with other assets. $hus, e+amining the
variance-covariance matri+, the third security must
e the riskfree asset.
. r
p ( .:
1
r1
/ , .:
!
r2
/
( ..1) 1).12/ , ..1) 3.52/
( 4.)2

p
i
n
i j ij
j
n
X X =

= =

1 1
1 2 /
( .X
1
X
1

11
,X
!
X
!

!!
, !X
1
X
!

1!
/
A
( B6..1)/C !1)7 , 6..1)/C 4)7
, .!/ ..1)/ ..1)/ .8)/D
A
( 61!.1 , !!.1 , #)7
A
( 61)17
A
( 1).!2
c. rtp
( ..31 r
p / , ..!1 r
#
/
( ..31 4.)2/ , ..!1 1.)2/
( 5.)2

tp
( .31
p
( .31 1).!2
( 3.32
11. $he efficient set would e composed of the southwest
portion of the curved &arkowit% efficient set .that is,
the efficient set without riskfree orrowing or lending/
up to the tangency portfolio .when oth riskfree
orrowing and lending are permitted/, where it would then
ecome a ray emanating from the tangency portfolio and
e+tending out into risk-return space. If this ray were
e+tended to the southwest, it would intersect the return
a+is at the riskfree rate.
18. $he effect is to increase oth e+pected return and risk.
$he investor is leveraging his or her invested position.
Since the optimal risky portfolio has a higher expected
return than the riskfree asset, the e+pected return on
the leveraged risky portfolio is higher than that of the
unleveraged portfolio.
<owever, ecause the risky portfolio's return is
variale, the leveraged risky portfolio's return is more
variale and hence more risky than the return on the
unleveraged risky portfolio.
13. Eour optimal risky portfolio would not change .assuming
the feasile investment opportunities did not change/.
It would remain the only risky portfolio lying on the
efficient set. <owever, your allocations to the riskfree
asset and the risky portfolio would change as your risk
preferences changed. As you ecame less risk averse, you
would decrease .increase/ your riskfree lending
.orrowing/ and move to the northeast along the efficient
set.
15. $he efficient set ecomes divided into three segments.
$he first segment is a straight line etween the lending
rate on the return a+is and tangent to the curved
&arkowit% efficient set .that is, the efficient set
without riskfree orrowing or lending/. $he second
segment lies to the northeast of the first. It is a
straight line tangent to the curved &arkowit% efficient
set, e+tending northeast into risk-return space. Fhile
this line does not e+tend to the return a+is, if it did
it would intersect the a+is at the orrowing rate. $he
third segment lies etween the first two. It is the
portion of the curved &arkowit% efficient set that lies
etween the two tangency portfolios.
14. G0uation .5.11/ shows that the optimal allocation to the
tangency portfolio is given y'
Y
r r
a
T
f
T
=

2
2

In =icklesH case,
Y =


. .
. .
12 04
2 2 47 18
2
(.1)
;ecause the tangency portfolioHs composition is'
X.T/ (
.
.
.
.
18
30
24
28

Multiplying those proportions by .50 produces Pickles opti!l port"olio #hich

#ill be 50$ in%ested in the risk"ree !sset& '$ in%ested in security 1& 15$ in%ested in
security 2& 12$ in%ested in security 3& !nd 14$ in%ested in security 4.