Q11.

(pg299)
AssetExpectedReturnBetaResidualSD
A201.358
B181.871
C170.760
D121.055
SD
Tbills80
Passive
equityportfolio1623
Answer11MysoreUniversity
a.CalculatingtheAlphas,Expectedreturnandresidualvariance
Alpha()
i=ri[rf+i(rMrf)]

Expectedexcessreturn
E(ri)rf

A=20%[8%+1.3(16%8%)]=1.6%

20%8%=12%

B=18%[8%+1.8(16%8%)]=

18%8%=10%

4.4%
C=17%[8%+0.7(16%8%)]=3.4%
D=12%[8%+1.0(16%8%)]=

17%8%=9%
12%8%=4%

4.0%

StocksAandChavepositivealphas,whereasstocksBandDhavenegative
alphas.
Theresidualvariancesare:
2(eA)=582=3,364
2(eB)=712=5,041
2(eC)=602=3,600
2(eD)=552=3,025
b.

Toconstructtheoptimalriskyportfolio,(theexaminermaychangethequestion
slightly.Likethepossiblequestioncanbe(i)Constructoptimalriskyportfolio(ii)or
useTreynorBlacktechnique.Rememberthesequence,dowritetheformulasasthese
areimportant,solutionalonewillnothelp.)

wefirstdeterminetheoptimalactiveportfolio.UsingtheTreynorBlacktechnique,we
constructtheactiveportfolio:
A
B

0.000476
0.000873

0.6142
1.1265

C
D
Total

0.000944
0.001322
0.000775

1.2181
1.7058
1.0000

Donotbeconcernedthatthepositivealphastockshavenegativeweightsandvice
versa.Wewillseethattheentirepositionintheactiveportfoliowillbenegative,
returningeverythingtogoodorder.
Withtheseweights,theforecastfortheactiveportfoliois:
=[0.61421.6]+[1.1265(4.4)][1.21813.4]+[1.7058(4.0)]
=16.90%
=[0.61421.3]+[1.12651.8][1.21810.70]+[1.70581]=2.08
Thehighbeta(higherthananyindividualbeta)resultsfromtheshortpositionsin
therelativelylowbetastocksandthelongpositionsintherelativelyhighbeta
stocks.
2(e)=[(0.6142)23364]+[1.126525041]+[(1.2181)23600]+[1.705823025]
=21,809.6
e=147.68%
Here,again,theleveredpositioninstockB[withhigh2(e)]overcomesthe
diversificationeffect,andresultsinahighresidualstandarddeviation.The
optimalriskyportfoliohasaproportionw*intheactiveportfolio,computedas
follows:
w0

/ 2 (e )
16.90 / 21,809.6

0.05124
2
[E (rM ) rf ] / M
8 / 23 2

Thenegativepositionisjustifiedforthereasonstatedearlier.
Theadjustmentforbetais:
w*

w0
0.05124

0.0486
1 (1 ) w 0 1 (1 2.08)( 0.05124)

Sincew*isnegative,theresultisapositivepositioninstockswithpositivealphas
andanegativepositioninstockswithnegativealphas.Thepositionintheindex
portfoliois:
1(0.0486)=1.0486
c.

TocalculateSharpesmeasurefortheoptimalriskyportfolio,wecomputethe
informationratiofortheactiveportfolioandSharpesmeasureforthemarket
portfolio.Theinformationratiofortheactiveportfolioiscomputedasfollows:
A=/e)=16.90/147.68=0.1144
A2=0.0131

Hence,thesquareofSharpesmeasure(S)oftheoptimizedriskyportfoliois:

23

S 2 S 2M A 2
S=0.3662

0.0131 0.1341

ComparethistothemarketsSharpemeasure:
SM=8/23=0.3478
Thedifferenceis:0.0184
Notethattheonlymoderateimprovementinperformanceresultsfromthefactthatonlya
smallpositionistakenintheactiveportfolioAbecauseofitslargeresidualvariance.

d.M2alreadytaken,youwillrequiretocalculatetheportfoliostandarddeviationwith
P
theoptimumweightscalculatedabove
This time they may slightly change the question by asking either information
ratio or some other question like What should be the exact make-up of the
complete portfolio for an investor with a coefficient of risk aversion of 2.8?
The answer would be like given below
Tocalculatetheexactmakeupofthecompleteportfolio,wefirstcompute`themean
excessreturnoftheoptimalriskyportfolioanditsvariance.Theriskyportfolio
betaisgivenby:
P=wM+(wAA)=1.0486+[(0.0486)2.08]=0.95
E(RP)=P+PE(RM)=[(0.0486)(16.90%)]+(0.958%)=8.42%

2P 2P 2M 2 (e P ) (0.95 23) 2 (0.0486 2 ) 21,809.6 528.94

P 23.00%
SinceA=2.8,theoptimalpositioninthisportfoliois:

8.42
0.5685
0.01 2.8 528.94

Incontrast,withapassivestrategy:

8
0.5401
0.01 2.8 23 2

Thisisadifferenceof:0.0284
Thefinalpositionsofthecompleteportfolioare:

Bills
M
A
B
C
D

10.5685=
0.5685l.0486=
0.5685(0.0486)(0.6142)=
0.5685(0.0486)1.1265=
0.5685(0.0486)(1.2181)=
0.5685(0.0486)1.7058=

43.15%
59.61%
1.70%
3.11%
3.37%
4.71%

100.00%
[sumissubjecttoroundingerror]
NotethatMmayincludepositiveproportionsofstocksAthroughD.