TUTORIAL 6 PORTFOLIO AND CAPITAL MARKET THEORY Q1 BKM7Q4-10 A pension fund manager is considering three mutual funds.

. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a T-bill money market fund that yields a rate of 8%. The probability distribution of the risky funds is as follows: Expected Return Standard Deviation Stock fund (S) 20% 30% Bond fund (B) 12% 15% The correlation between the fund returns is 0.10. (i) What are the investment proportions in the minimum-variance portfolio of the two risky funds, and what is the expected value and standard deviation of its rate of return? (ii) Tabulate and draw the investment opportunity set of the two risky funds. Use investment proportions for the stock fund of zero to 100% in increments of 20%. (iii) Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the expected return and standard deviation of the optimal portfolio? (iv) Solve numerically for the proportions of each asset and for the expected return and standard deviation of the optimal risky portfolio. (v) What is the reward-to-volatility ratio of the best feasible CAL? (vi) You require that your portfolio yield an expected return of 14%, and that it be efficient, on the best feasible CAL. a. What is the standard deviation of your portfolio? b. What is the proportion invested in the T-bill fund and each of the two risky funds? (vii) If you were to use only the two risky funds, and still require an expected return of 14%, what would be the investment proportions of your portfolio? Compare its standard deviation to that of the optimized portfolio in part (vi) above. What do you conclude? Q2 BKM 7 Q12 Suppose that there are many stocks in the security market and that the characteristics of stocks A and B are given as follows: Stock Expected Return Standard Deviation A 10% 5% B 15% 10% Correlation = -1 Suppose that it is possible to borrow at the risk-free rate, rf . What must be the value of the risk free rate? (Hint: Think about constructing a risk-free portfolio from stocks A and B.) INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory Page 1 of 4

Q3 BKM 7Q15. Suppose you have a project that has a 0.7 chance of doubling your investment in a year and a 0.3 chance of halving your investment in a year. What is the standard deviation of the rate of return on this investment? Q4 BKM 7 Q16 Suppose that you have $1 million and the following two opportunities from which to construct a portfolio: a. Risk-free asset earning 12% per year. b. Risky asset with expected return of 30% per year and standard deviation of 40%. If you construct a portfolio with a standard deviation of 30%, what is its expected rate of return? Q5 BKM 8Q6 The following are estimates for two stocks. Stock Expected Return Beta Firm-Specific Standard Deviation A 13% 0.8 30% B 18% 1.2 40% The market index has a standard deviation of 22% and the risk-free rate is 8%. a. What are the standard deviations of stocks A and B? b. Suppose that we were to construct a portfolio with proportions: Stock A: .30 Stock B: .45 T-bills: .25 Compute the expected return, standard deviation, beta, and non-systematic standard deviation of the portfolio. Q6 BKM 8Q7 Consider the following two regression lines for stocks A and B in the following figure.

a. Which stock has higher firm-specific risk? b. Which stock has greater systematic (market) risk? INTRODUCTION TO ACTUARIAL SCIENCE 2013-14/S1: Tutorial 6 Portfolio & Capital Market Theory Page 2 of 4

c. Which stock has higher R2 ? d. Which stock has higher alpha? e. Which stock has higher correlation with the market? Q7 BKM 8Q8 Consider the two (excess return) index model regression results for A and B: Rsquare = 0.576 Residual standard deviation = 10.3%

Rsquare = 0.436 Residual standard deviation = 9.1% a. Which stock has more firm-specific risk? b. Which has greater market risk? c. For which stock does market movement explain a greater fraction of return variability? d. If r f were constant at 6% and the regression had been run using total rather than excess returns, what would have been the regression intercept for stock A? Q8 BKM 8CFA2 Assume the correlation coefficient between Baker Fund and the S&P 500 Stock Index is 0.70. What percentage of Baker Funds total risk is specific (i.e., non-systematic)? Q9 BKM 9Q3 Are the following true or false? Explain. a. Stocks with a beta of zero offer an expected rate of return of zero. b. The CAPM implies that investors require a higher return to hold highly volatile securities. c. You can construct a portfolio with beta of .75 by investing .75 of the investment budget in T-bills and the remainder in the market portfolio. Q10 BKM 9Q20 Two investment advisers are comparing performance. One averaged a 19% rate of return and the other a 16% rate of return. However, the beta of the first investor was 1.5, whereas that of the second was 1. a. Can you tell which investor was a better selector of individual stocks (aside from the issue of general movements in the market)? b. If the T-bill rate were 6% and the market return during the period were 14%, which investor would be the superior stock selector? c. What if the T-bill rate were 3% and the market return were 15%?

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Q11 BKM 9Q21 Suppose the rate of return on short-term government securities (perceived to be risk-free) is about 5%. Suppose also that the expected rate of return required by the market for a portfolio with a beta of 1 is 12%. According to the capital asset pricing model: a. What is the expected rate of return on the market portfolio? b. What would be the expected rate of return on a stock with = 0? c. Suppose you consider buying a share of stock at $40. The stock is expected to pay $3 dividends next year and you expect it to sell then for $41. The stock risk has been evaluated at = -0.5. Is the stock overpriced or underpriced?

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