PS04-solution

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Problem Set 4: Solutions UCLA MQE Core Finance Prof. Pierre-Olivier Weill 1. Consider two risky assets with returns r 1 and r 2 . Assume that the expected returns, standard deviations are ¯ r 1 = 0 . 03, ¯ r 2 = 0 . 08, σ 1 = 0 . 05, σ 2 = 0 . 1. Write a Python program to plot, on the same diagram, the investment opportunity set when the correlation is ρ 12 = 1, ρ 12 = 0 . 1 and ρ 12 = +1. Assume for this calculation that portfolio weights are positive. Answer: Please see the Jupyter notebook on the website. 2. Consider two risky assets with returns r 1 and r 2 . Assume that the expected returns satisfy ¯ r 1 < ¯ r 2 , the standard deviation σ 1 < σ 2 and the correlation is ρ ̸ = 0. (a) Suppose that we combine the two assets in a portfolio with weights w 1 and w 2 with w 1 + w 2 = 1. Find a formula for the portfolio weights, w 1 and w 2 , of the minimum variance portolio. Answer: The formula for the variance of this portfolio is Var( w ) = w 2 1 Var( r 1 ) + w 2 2 Var( r 2 ) + 2 w 1 w 2 Cov( r 1 , r 2 ) . We know that w 1 + w 2 = 1, and thus w 2 = 1 w 1 . Then, we can write the variance of the portfolio as Var( w ) = w 2 1 Var( r 1 ) + (1 w 1 ) 2 Var( r 2 ) + 2 w 1 (1 w 1 )Cov( r 1 , r 2 ) . Now we can take the derivative of the variance with respect to w 1 to find the minimum of this function: 0 = 2 w 1 Var( r 1 ) 2(1 w 1 )Var( r 2 ) + 2(1 2 w 1 )Cov( r 1 , r 2 ) w 1 [2Cov( r 1 , r 2 ) Var( r 1 ) Var( r 2 )] = Cov( r 1 , r 2 ) Var( r 2 ) . Taken together we obtain: w 1 = Cov( r 1 ,r 2 ) Var( r 2 ) 2Cov( r 1 ,r 2 ) Var( r 1 ) Var( r 2 ) w 2 = Cov( r 1 ,r 2 ) Var( r 1 ) 2Cov( r 1 ,r 2 ) Var( r 1 ) Var( r 2 ) .
(b) Derive a condition on ρ for the investment opportunity set to be backward bending. Explain why the investment opportunity set is not always backward bending. Answer: We have already found the minimum. We would like to show that the variance of the portfolio is decreasing in w 2 (the weight of the asset with the large variance) when w 2 = 0 and increasing in w 2 when w 2 = 1. First, we take the partial derivative of the variance of the portfolio Var( w ) with respect to w 2 and evaluate it when w 2 = 0: Var ( w ) ∂w 2 w 2 =0 = [(1 w 2 ) 2 Var( r 1 ) + w 2 2 Var( r 2 ) + 2(1 w 2 ) w 2 ρσ ( r 1 ) σ ( r 2 )] ∂w 2 w 2 =0 = [ 2(1 w 2 )Var( r 1 ) + 2 w 2 Var( r 2 ) + 2 (1 2 w 2 ) ρσ ( r 1 ) σ ( r 2 )] w 2 =0 = 2Var( r 1 ) + 2 ρσ ( r 1 ) σ ( r 2 ) We need that Var( w ) ∂w 2 w 2 =0 < 0, then: 2Var( r 1 ) + 2 ρσ ( r 1 ) σ ( r 2 ) < 0 ρ < Var( r 1 ) σ ( r 1 ) σ ( r 2 ) = σ ( r 1 ) σ ( r 2 ) Second, we take the partial derivative of the variance of the portfolio Var( w ) with respect to w 2 and evaluate it when w 2 = 1: Var ( w ) ∂w 2 w 2 =1 = [(1 w 2 ) 2 Var( r 1 ) + w 2 2 Var( r 2 ) + 2(1 w 2 ) w 2 ρσ ( r 1 ) σ ( r 2 )] ∂w 2 w 2 =1 = [ 2(1 w 2 )Var( r 1 ) + 2 w 2 Var( r 2 ) + 2 (1 2 w 2 ) ρσ ( r 1 ) σ ( r 2 )] w 2 =1 =2Var( r 2 ) 2 ρσ ( r 1 ) σ ( r 2 ) We need that Var( w ) ∂w 2 w 2 =1 > 0, then: 2Var( r 2 ) 2 ρσ ( r 1 ) σ ( r 2 ) > 0 ρ < Var( r 2 ) σ ( r 1 ) σ ( r 2 ) = σ ( r 2 ) σ ( r 1 ) So, we should have that ρ < σ ( r 1 ) σ ( r 2 ) < σ ( r 2 ) σ ( r 1 ) , given σ ( r 2 ) > σ ( r 1 ).
(c) Suppose that ρ = 1. Show that it is possible in this case to create a portfolio with zero risk. What are the portfolio weight of the zero risk portfolio if σ 1 = σ 2 ? What about σ 1 < σ 2 ? Explain the intuition. Answer: We would like to find the weights w 1 and w 2 that make the variance equal to 0: Var( w ) = w 2 1 Var( r 1 ) + (1 w 1 ) 2 Var( r 2 ) + 2 w 1 (1 w 1 ) ρ |{z} -1 σ ( r 1 ) σ ( r 2 ) 0 = w 2 1 Var( r 1 ) + (1 w 1 ) 2 Var( r 2 ) + 2 w 1 (1 w 1 ) ( 1) σ ( r 1 ) σ ( r 2 ) 0 = w 2 1 Var( r 1 ) + (1 2 w 1 + w 2 1 )Var( r 2 ) + 2( w 2 1 w 1 ) σ ( r 1 ) σ ( r 2 ) 0 = [Var( r 1 ) + Var( r 2 ) + 2 σ ( r 1 ) σ ( r 2 )] w 2 1 2 [Var( r 2 ) + σ ( r 1 ) σ ( r 2 )] w 1 + [Var( r 2 )] Now we can use the formula for the roots of a quadratic equation for solving the values of w 1 the equation above: 0 = aw 2 1 + bw 1 + c . If you do that you will find that this equation has only one root: w 1 = Var( r 2 ) + σ ( r 1 ) σ ( r 2 ) Var( r 1 ) + Var( r 2 ) + 2 σ ( r 1 ) σ ( r 2 ) = σ ( r 2 ) ( ( ( ( ( ( (( [ σ ( r 1 ) + σ ( r 2 )] [ σ ( r 1 ) + σ ( r 2 )] 2 w 1 = σ ( r 2 ) σ ( r 1 ) + σ ( r 2 ) w 2 = Var( r 1 ) + σ ( r 1 ) σ ( r 2 ) Var( r 1 ) + Var( r 2 ) + 2 σ ( r 1 ) σ ( r 2 ) = σ ( r 1 ) ( ( ( ( ( ( (( [ σ ( r 1 ) + σ ( r 2 )] [ σ ( r 1 ) + σ ( r 2 )] 2 w 2 = σ ( r 1 ) σ ( r 1 ) + σ ( r 2 ) If σ 1 = σ 2 then w 1 = w 2 = 0 . 5. If σ 1 < σ 2 then w 1 > w 2 . (d) What must be the relationship between the zero risk portfolio you constructed in the previous question and the return on a risk free asset? Answer: They must be the same. If not there would be arbitrage opportunities. 3. Consider the following data: Expected Return Standard Deviation Russell Fund 16% 12% Windsor Fund 14% 10% S&P Fund 12% 8%
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The correlation between the returns on the Russell Fund and the S&P Fund is .7. The rate on T-bills is 6%. Which of the following portfolios would you prefer to hold in combination with T-bills and why? Russell Fund Windsor Fund S&P Fund A portfolio of 60% Russell Fund and 40% S&P Fund. Answer: We need to calculate and compare the Sharpe ratios for the assets because investors want to invest in a portfolio with the highest possible Sharpe ratio: RF SR = 0 . 16 0 . 06 0 . 12 = 0 . 83 WF SR = 0 . 14 0 . 06 0 . 10 = 0 . 8 S&P SR = 0 . 12 0 . 06 0 . 18 = 0 . 75 To analyse the Sharpe Ratio of the portfolio composed by 60% of Russell Fund and 40% of S&P Fund, we must first calculate its standard deviation and expected return. First, we calculate the standard deviation: σ (0 . 6 × RF + 0 . 4 × S&P) = p 0 . 6 2 × Var(RF) + 0 . 4 2 × Var(S&P) + 2 × ρ × 0 . 6 × 0 . 4 × σ ( RF ) × σ ( S & P ) = = 0 . 6 2 × 0 . 12 2 + 0 . 4 2 × 0 . 08 2 + 2 × 0 . 7 × 0 . 6 × 0 . 4 × 0 . 12 × 0 . 08 = 9 . 71% Now we calculate the expected return: ER { 0 . 6 × RF+0 . 4 × S&P } = 0 . 6 × 16% + 0 . 4 × 12% = 14 . 4% Now, we can calculate the Sharpe ratio: { 0 . 6 × RF + 0 . 4 × S&P } SR = 0 . 144 0 . 06 0 . 0971 = 0 . 87 You would prefer to hold a portfolio of 60% Russell Fund and 40% S&P Fund.