Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
c6
Student: _
1.
You are considering investing $1,000 in a Tbill that pays 0.05 and a risky
portfolio, P, constructed with 2 risky securities, X and Y. The weights of X and Y
in P are 0.60 and 0.40, respectively. X has an expected rate of return of 0.14
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
CAPM EXERCISE Taken from Ch 7 in the textbook
With the CAPM Model, are the following scenarios valid? Why or why not?
Portfolio
A
B
Expected return
.20
.25
Beta
1.4
1.2
No, this would not be able to. Because the beta of the higher return is higher than th
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Ch 5 Questions for Review
You manage a risky portfolio with an expected rate of return of 18 percent and a standard deviation of 28
percent. The Tbill rate is 8 percent. Use these data for problems 1019.
10. Your client chooses to invest 70 percent of a
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Class exercise ch 6
Consider two perfectly negatively correlated
risky securities A and B. A has an expected
rate of return of 10% and a standard deviation
of 16%. B has an expected rate of return of 8%
and a standard deviation of 12%.
The weights of A a
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Utility max
1 RiskFree Asset and 1 Risky
Asset
Suppose we construct a portfolio P consisting of
1 riskfree asset f and 1 risky asset A:
E (rp ) w f r f w A E (rA )
2
p
2
A
=w 00
2
A
p = wA A
Note: The variance of the riskfree asset is 0, and the cova
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
CAPM class
exercise
3.
A rewardtovolatlity rato is useful in:
A. measuring the standard deviaton of returns.
B. understanding how returns increase relatve to risk increases.
C. analysing returns on variable rate bonds.
D. assessing the effects of inflat
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Ch 6 part II
Imagine a world with
2 risky securities and 1 riskfree
security
2
Two Feasible CALs
The two lines:
How much return you get for
1 unit of risk
A= minimum variance
portfolio
3
This lower part is
called dominated
portfolio,
They have the same
r
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Capital Asset Pricing Model
CAPM I: The Theory
CAPM
Builds on portfolio theory but contains all
assets.
All investors seek the tangency portfolio
The exact distribution of the risk free asset
and the market portfolio depends on U
function ( in particula
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Answers
12. Since A and B are perfectly negatively correlated, a riskfree portfolio can be created and
its rate of return in equilibrium will be the riskfree rate. To find the proportions of this
portfolio (with wA invested in A and wB = 1 wA in B), set
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Class exercise ch 5
You put the answers on the word
doc.
Suppose we manage a portfolio with E(p) of
18% and SD of 28%.
T bill rate is 8%
A client wants to invest 70% in our fund and
30% in Tbills.
What is the expected return and SD of the
clients pro
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
c5
Student: _
1.
A Tbill pays 6 percent rate of return. Would riskaverse investors invest in a
risky portfolio that pays 12 percent with a probability of 40 percent or 2 percent
with a probability of 60 percent?
A.
B.
C.
D.
E.
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
c4
Student: _
1.
Over the past year you earned a nominal rate of interest of 10 percent on your
money. The inflation rate was 5 percent over the same period. The exact actual
growth rate of your purchasing power was
A.
B.
C.
D.
E.
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
c9
Student: _
1.
If you believe in the _ form of the EMH, you believe that stock prices
reflect all relevant information including historical stock prices and current
public information about the firm, but not information that is available only to
insider
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
c10
Student: _
1.
Psychologists have found that people who make decisions that turn out badly
blame themselves more when that decision was unconventional. The name for
this phenomenon is
A.
B.
C.
D.
E.
Western University (Ontario)  Also known as University of Western Ontario
econ2181
ECONOMICS 2181

Winter 2016
Ch 6 part 2
Imagine a world with
2 risky securities
2
Expected Return and Standard Deviation
with Various Correlation Coefficients
3
73
73
Portfolio Expected Return as a Function of Investment Proportions
4
74
74
Perfect Correlation
E(R)
0.20
0.15
0.1