Principles of Corporate Finances Chapter 8

Chapter 08 - Portfolio Theory and the Capital Asset Pricing Model

CHAPTER 8

Portfolio Theory and the Capital Asset Pricing Model

Answers to Problem Sets

1.

a.

(.5 x 0%) + (.5 x 14%) = 7%.

b.

With Perfect Positive Correlation:

Portfolio variance =

[(.5)2 x (28) 2] + [(.5) 2 x (26) 2] + 2 (.5 x .5 x 1 x 28 x 26) = 729

Standard deviation = the square root of 729 = 27%.

With Perfect Negative Correlation:

Portfolio variance =

[(.5) 2 x (28) 2] + [(.5) 2 x (26) 2] + 2 (.5 x .5 x -1 x 28 x 26) = 1

Standard deviation = the square root of 1 = 1%.

With no correlation:

Portfolio variance =

[(.5) 2 x (28) 2] + [(.5) 2 x (26) 2] + 2 (.5 x .5 x 0 x 28 x 26) = 365

Standard deviation = the square root of 365 = 19.1%.

c.

See Figure 1 below.

d.

No, measure risk by beta, not by standard deviation.

8-1

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Chapter 08 - Portfolio Theory and the Capital Asset Pricing Model

Est. Time: 06- 10

2.

a.

Portfolio A (higher expected return, same risk)

b.

Cannot say (depends on investor’s attitude -toward risk)

c.

Portfolio F (lower risk, same expected return)

Est. Time: 01 - 05

3.

The long-term risk premium for securities as shown in Chapter 7 is 7.3%, and the

long-term standard deviation for security returns is 20.0%. Therefore the Sharpe

ratio = 7.3/20.0 = .365.

Est. Time: 01 - 05

4.

a.

Figure 8.11b: Diversification reduces risk (e.g., a mixture of portfolios A

and B would have less risk than the average of A and B).

b.

c.

Those along line A in Figure 8.11a

See Figure 2 below.

Est. Time: 01 - 05

5.

a.

See Figure 3 below.

8-2

© 2014 by McGraw-Hill Education. This is proprietary...