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1a.

You are given the following information about a portfolio consisting of stocks A, B and C:
You have $20000 invested in A with an expected return of 8%; you have $30000 invested in B
with an expected return of 12%; and $50000 invested in C with an expected return of 16%.
What is the expected return of the portfolio? Show you calculations below. *
Total investment = 20000+30000+50000 = 100000
Expected return of portfolio = (20000/100000)×8%+ (30000/100000)×12%+
(50000/100000)×16% = 13.2%

1b. Which is the correct answer? *


1 point

13.2
10.4
9.8
12.3
Other:

2a. If your objective is to reduce the standard deviation of returns on a portfolio by the
greatest amount, you should add a security: *
2 points

that has a lower standard deviation of returns than other securities in the portfolio
That has a beta less than one
That has returns that are uncorrelated with the returns on all other securities in the portfolio
That has returns that are positively correlated with the returns on other securities in the portfolio

2b. Explain why you selected the option above in 2a. *

While calculating portfolio standard deviation, the covariance or correlation is


considered as part of it. Hence, if we choose to add an uncorrelated stock in the
portfolio, it will result in zero at the part of the calculation of portfolio standard
deviation where the covariance is multiplied with the weights of the corresponding
stocks and will reduce the standard deviation to the greatest extent. Theoretically, if
any stock has no correlation to the other stocks of the portfolio then this security might
yield in profit or gain when all the other securities move to opposite direction which will
reduce the risk as well of the portfolio.

3a. If a Treasury bill pays 5%, which of the following would definitely not be chosen by
a risk averse investor: *
2 points

An asset paying 10%, with probability .6 or 2% with probability .4


An asset paying 10% with probability .4 or 2% with probability .6
An asset paying 10% with probability .2 or 3.75% with probability. 8
An asset paying 10% with probability .3 or 3.75% with probability .7

3b. Explain how you arrived at your answer for 3a above *

Expected returns for the above options are:


Option A: 10%×.6+2%×.4 = 6.80%
Option B: 10%×.4+2%×.6=5.20%
Option C: 10%×.2+3.75%×.8=5%
Option D: 10%×.3+3.75%×.7= 5.63%
Since option C provides return of 5% with some inherent risks and T bill provides the
same return without any risk, as a risk averse investor, people should choose the less
risky opportunity at the same return level.

4a. Which of the following is not possible when two securities are positively
correlated. *
2 points

Asset A's mean return is negative while asset B's is positive


Asset A's return is sometimes below its mean when asset B's is above its mean
Asset A's mean return is negative while asset B's mean return is also negative
All are possible

4b. Explain why you selected the answer to 4a above. *


Correlation is calculated based on the movement of the stocks on a regular frequency.
It is possible that the return of A is always negative and it gives negative mean and all
returns of B is positive and gives positive mean. However, they still can be positively
correlated as when the return of B increases, the returns of A becomes less negative
and as such they remain positively correlated. The 2nd option is also viable because
the returns of both the stocks might move to similar direction irrespective of their
means. Also, the returns of A and B can always be negative and thus their means
could be negative. But they still can be positively correlated as their returns might be
less negative most of the times or more negative most of the times. Hence, all the
options are possible.
5a. The equilibrium market price of risk *
2 points

Is higher when investors are more risk averse


Is fixed by the risk-free rate
Cannot be greater than one
All of the above

5b. Explain why you selected the answer to 5a above *


Equilibrium market price of risk would be higher if the investors are more risk averse
and are demanding higher risk premium for every level of risk they take. And due to
this the Capital Market Line would be steeper and slope will be higher resembling the
higher risk averse attitude by the investors. Risk free rate is not the only determinant
of the equilibrium market price of risk, but also the expected return of market portfolio
along with the risk of market portfolio plays a vital role as well. If the slope is very
steep for CML then it can be greater than one.

6a. Risk-neutral investors are more likely to invest in: *


2 points

The least risky portfolio on the efficient frontier of risky securities


The riskiest portfolio on the efficient frontier of risky securities.
The market portfolio
Only the risk-free asset
The market portfolio leveraged by the risk-free asset.

6b. Provide your rationale for selecting your answer to 6a. above. *

Risk neutral investors are the investors who only considers the potential gain and
ignores the risk. In the above options, they will not invest in the 1 st four options as
borrowing at risk free rate and investing it in risky assets would yield in higher returns
at the expense of higher risk as the risk and return linearly increase along the CML.

7. Why does investment theory talk about an Optimal Portfolio? *


An optimal portfolio is the portfolio which yields the maximum return for an investor at
the given risk level of the investor chooses to accept. An optimal portfolio for two
investors with same wealth and operating in the same market would be different
considering their response to risk. Generally, the optimal portfolio is referred to as the
portfolio which lies in on the efficient frontier which is tangent to the highest utility
curve possible. Based on the attitude towards risk, the utility curves for more risk
averse investor would be steeper and the utility curves for less risk averse investors
would be flatter and this will change the optimal portfolio for the investors in the same
efficient frontier but with different risk attitude. Based on this attitude towards risk, the
investment decisions and the required rate of return would be different for every
investors.

8a. Give four arguments in favour of adding international securities to your portfolio. *

(a) It increases the investment choices in order to get higher return at a lower risk level
(b) It provides opportunity to invest in international securities which might yield higher
returns compared to the local securities, especially in emerging markets.
(c) By investing in the countries which has negative correlation with the local country’s
economy provides the opportunity to diversify the portfolio
(d) Investors can take the advantage of exchange rate fluctuation by investing in
foreign market when the local currency is strong and take back the return when the
local currency devaluates.

8b. There are a number of potential problems associated with moving away from a domestic-
securities-only orientation. Identify and explain four of the potential problems. *

(a) Country specific political risk raises concerns for the investment in that country
(b) The exchange rate may move against the benefits of the investor and might result
in loss for the investor
(c) There might be liquidity risks in some countries where it would be difficult to sell off
the investment and to get the investment return to the local country
(d) Many of the governments in the emerging economies have additional taxation for
the international investors

9a. Differentiate between Systematic and Unsystematic risk. *


Unsystematic risk refers to the unique risk associated only with individual asset,
whereas systematic risk is the risk which is determined as the variability in the return
of the risky assets caused by macroeconomic variables which are not unique to
individual assets. Through diversification of the portfolio by adding negatively
correlated securities, the unsystematic risk can be eliminated whereas the systematic
risk cannot be eliminated. The systematic risk is common for the industry whereas the
unsystematic risk is security or asset specific. Examples of systematic risk would be
inflation, interest rate movement, unemployment etc. And for unsystematic risk
examples would be inefficiency in operation resulting higher cost, higher employee
turnover etc.

9b. There many different sources of risk that need to be considered when investing. Identify
and explain 3 different types of risk that an investor needs to understand. *

There are five different types of risks to be considered while investing and three of
them are provided below:
(a) Business risk is the risk of unstable income flow from any business which leads to
uncertain income flow to the investors as well. When any business like restaurant has
stable income flow the business risk is deemed as low compared to any art gallery
where the income flow is highly uncertain. Higher the business risk, higher the risk
premium charged by the investors.
(b) Financial risk arises when a firm is highly leveraged and incurs huge debt servicing
cost as it reduces the income stream to the common shareholders or investors. Higher
the leverage for financing fixed assets, higher the financial risk of a firm. For any firm
with increased financial risk, the investors should claim for risk premium as
compensation for their additional risk.
(c) Liquidity risk is assumed by the investors for any asset in the secondary market
regarding the quick salability at less or no loss of the value. If the asset demands
higher time to sale or quick sale at a discounted price then the liquidity risk is higher.
Along with the above mentioned risks, there are exchange rate risk and country risk
which are which are not under control of the investor, hence considered as systematic
risk which cannot be diversified. And the investor must charge higher risk premium if
the above risks are higher in terms of investment.

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