Tarun Singh

Worked with Cliff Beltzer

Ec 1745 Problem Set 3

1. a) $900k = (.55($900k(1+r))+(.45($500k)))/(1.10) → r = .5454 = 54.54%

b) $1000k = (.55($1000k(1+r))+(.45($500k)))/(1.10) → r = .5909 = 59.09%

2. a) PV(B) = (((.5($50M))+(.5($20M))) /(1) = $35M

PV(E) = (((.5($50M))+(.5($0)))/(1) = $25M
b) DP = (($50M/$35M)-1) = .4286 = 42.86%
c) Return (Bond in Sunshine) = (($50M/$35M)-1) = .4286 = 42.86%
Return (Bond in Rain) = (($20M/$35M)-1) = -.4286 = -42.86%
d) Return (Equity in Sunshine) = (($50M/$25M)-1) = 1 = 100%
Return (Equity in Rain) = (($0/$25M)-1) = -1 = -100%
e) i) Bond: Sunshine- $50M , Rain- $30M
Equity: Sunshine- $40M, Rain- $0
ii) PV(B) = (((.5($50M))+(.5($30M)))/(1) = $40M
PV(E) = (((.5($40M))+(.5($0)))/(1) = $20M
iii) Return (Bond in Sunshine) = (($50M/$40M)-1) = .25 = 25%
Return (Bond in Rain) = (($30M/$40M)-1) = -.25 = -25%
Return (Equity in Sunshine) = (($40M/$20M)-1) = 1 = 100%
Return (Equity in Rain) = (($0/$20M)-1) = -1 = -100%
iv) The owners would not be tempted to reorganize because reorganization
would only lower the expected positive returns on bonds and would have
no impact on the returns to equity.
f) i) Bond: Sunshine- $50M , Rain- $10M
Equity: Sunshine- $60M, Rain- $0
ii) PV(B) = (((.5($50M))+(.5($10M)))/(1) = $30M
PV(E) = (((.5($60M))+(.5($0)))/(1) = $30M
iii) Return (Bond in Sunshine) = (($50M/$30M)-1) = .6667 = 66.67%
Return (Bond in Rain) = (($10M/$30M)-1) = -.6667 = -66.67%
Return (Equity in Sunshine) = (($60M/$30M)-1) = 1 = 100%
Return (Equity in Rain) = (($0/$30M)-1) = -1 = -100%
iv) The owners would be tempted to reorganize because reorganization
would only increase the expected positive returns on bonds and would
have no impact on the expected returns to equity.

3. a) E(RBonds) = ((.3(.16))+(.4(.06))+(.3(-.04))) = .06 = 6%

Var(RBonds) = ((.3(.16-.06)2)+(.4(.06-.06)2)+(.3(-.04-.06)2)) = .006
S.D.(RBonds) = √(.006) = .07746 = 7.746%
E(RStocks) = ((.3(-.11))+(.4(.13))+(.3(.27))) = .10 = 10%
Var(RStocks) = ((.3(-.11-.10)2)+(.4(.13-.10)2)+(.3(.27-.10)2)) = .02226
S.D.(RStocks) = √(.02226) = .149198 = 14.9198%
b) Cov(RB,Rs) = ((.3(-.21)(.10))+(.4(.03)(0))+(.3(.17)(-.10))) = -.0114
 Cov(RB,Rs) = ρ(S.D.(RStocks)) (S.D.(RBonds))
Corr(RB,Rs) = ρ = -.0114/((.07746)(.149198)) = -.986426
c) E(RPort) = ((.5(.06))+(.5((.10))) = .08 = 8%
Var(RPort) = ((.52)(.006))+ ((.52)(.02226))+ (2(.5)(.5)(-.0114))) = .001365
S.D.(RPort) = √(.001365) = .036946 = 3.6946%
d) An investor with these preferences prefers the equal-weighted portfolio to
bonds because no matter what the value of k is, the portfolio yields a higher
return and has a lower variance than the bonds. Thus in order, to maximize
his/her utility the investor ought to choose the equal-weighted portfolio
assuming the risk aversion constant is positive.

4. a)

Looking at the graph I would guess that the portfolio where w=.55 has the
lowest variance.
b) Var(Rp) = w2Var(Ri)+(1-w)2Var(Rj)+2w(1-w)Cov(Ri,Rj)
∂Var(Rp)/∂w = 2w(Var(Ri))+2(1-w)(Var(Rj))+2(1-2w)Cov(Ri, Rj)
0 = 2w(Var(Ri))+2(1-w)(Var(Rj))+2(1-2w)Cov(Ri, Rj)

→w = (Var(Rj)-Cov(Ri, Rj))/(Var(Ri)+Var(Rj)-2Cov(Ri,Rj))
Cov(Ri,Rj) = (-.9)(.010.5) (.015.5) = -.011
→ w = (.015-(-.011))/(.010+.015-2(-.011)) = .55314 = 55.314%