FINA411 AA Fall2022 Assignment 2 solutions

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Concordia University *

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411

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Finance

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Apr 3, 2024

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John Molson School of Business FINA 411 AA - Page 1 Usual Copyright Disclaimer applies. ASSIGNMENT 2 FINA 411AA Solution sketch Selected Exercises 1. The following data is available on 3 stocks A, B, C: 𝐸(𝑅 ? ) = 𝐸(𝑅 ? ) = 𝐸(𝑅 ? ) 𝜎 ? = 𝜎 ? = 𝜎 ? 𝜌 (?,?) = +0.9 𝜌 (?,?) = −0.2 𝜌 (?,?) = +0.3 Portfolio of which two stocks will have the lowest standard deviation? Explain and include all steps necessary to arrive at the solution. The portfolio constructed containing stocks B and C would have the lowest standard deviation. Combining assets with equal risk and return but with low positive or negative correlations will reduce the risk level of the portfolio. 2. An analyst in the search for investment opportunities is evaluating the following five portfolios of risky assets, which are well-diversified (assume risk-free rate of 3.75 %): Portfolio Exp. Return St. Dev. A 8.00% 11.00% B 11.00% 14.50% C 5.00% 5.00% D 11.80% 20.00% E 6.40% 8.00%
John Molson School of Business FINA 411 AA - Page 2 Usual Copyright Disclaimer applies. a. Estimate the risk premium per unit of risk expected to be received per each portfolio. Estimates of (E(R)-Rf)/std: A 0.386 B 0.500 C 0.250 D 0.403 E 0.331 b. Which of the five portfolios is most likely to be the market portfolio? Draw the CML (define the numerical values of the intercept and slope next to the graph). The CML slope, [E(R MKT ) - RFR ]/ σ MKT , is the ratio of risk premium per unit of risk. Portfolio B has the highest ratio, 0.5000, of these five portfolios, so it is most likely the market portfolio. Thus, the slope of the CML is 0.5 and its intercept is 3.75%, which is the risk-free rate. c. Suppose the analyst ’s preference is only for making an investment with 𝜎 = 8% , and earning a 10% return. Would this be possible? The CML equation, based on the above analysis, is E(R portfolio ) = 3.75 % + (0.50) σ portfolio . If the desired standard deviation is 8.0%, then the expected portfolio return is 7.75%: E(R portfolio ) = 3.75% + (0.50) (8%) = 7.75% . The answer is no, it is not possible to earn an expected return of 10% with a portfolio with standard deviation of 8%. Risky portfolio R_f 0% 5% 10% 15% 20% 0% 5% 10% 15% 20% 25% 30% 35% Expected Return Standard Deviation Capital Allocation Line
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