Question #1:  Capital Allocation:

Consider the following capital market: a risk-free asset yielding 1.00% per year and a mutual fund consisting of 60% stocks and 40% bonds. The expected return on stocks is 9.75% per year and the expected return on bonds is 2.75% per year. The standard deviation of stock returns is 28.00% and the standard deviation of bond returns 8.50%. The stock, bond and risk-free returns are all uncorrelated.

1. What is the expected return on the mutual fund?

2. What is the standard deviation of returns for the mutual fund?

Now, assume the correlation between stock and bond returns is 0.60 and the correlations between stock and risk-free returns and between the bond and risk-free returns are 0 (by construction, correlations with the risk-free asset are always zero).

3. What is the standard deviation of returns for the mutual fund? Is it higher or lower than the standard deviation found in part 2? Why?

Now, assume that the standard deviation of the mutual fund portfolio is exactly 19.75% per year and a potential customer has a risk-aversion coefficient of 3.25.

4. What correlation between the stock and bond returns is consistent with this portfolio standard deviation?

5. What is the optimal allocation to the risky mutual fund (the fund with exactly 19.75% standard deviation) for this investor?

6. What is the expected return on the complete portfolio?

7. What is the standard deviation of the complete portfolio?

8. What is the Sharpe ratio of the complete portfolio?

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Question #2:  Markowitz Optimization:

Open the associated Excel file named QPS2 Data Fall 2014 Problem 2 in My Course Content:  Problem Set Spreadsheets. The data file includes 60 months of returns for 11 exchange traded funds; their names and ticker symbols follow:

All students will do problem 2 using 9 of the above ETFs; all students will include the first 8 ETFs listed above:  SPY, MDY, IWM, QQQ, EFA, VWO, VNQ, and BND.  All students will include one of the last 3 ETFs:  PFF, GLD, and JNK as instructed on your version.

Version A:  Include PFF and exclude GLD and JNK. 

Use the data on your 9 ETFs to answer the following questions:

1.  What is the average return for each of the nine indexes?

2.  Show the covariance matrix of returns. Briefly describe how you constructed the covariance matrix.

Consider the simple case where short sales are allowed. Use Excel Solver to find the Minimum Variance Portfolio (MVP).

3.  What is the expected portfolio return for the MVP portfolio?

4.  What is the portfolio standard deviation for the MVP portfolio?

5.  What is the portfolio composition (i.e., what are the weights for the nine ETFs)?

Consider the simple case where short sales are allowed, but short positions must be greater than or equal to -100% and long positions must be less than or equal to 100%. Use Excel Solver to find the Maximum return portfolio with a standard deviation of exactly 6.75%.

6.  What is the expected portfolio return for this portfolio?

7.  What is the portfolio composition (i.e., what are the weights for the nine ETFs)?

Consider the more realistic case where short sales are NOT allowed and no more than 40% of the portfolio and no less than 4% is invested in any ETF. Use Excel Solver to find the Minimum Variance Portfolio (MVP).

8.  What is the expected portfolio return for the MVP portfolio?

9.  What is the portfolio standard deviation for the MVP portfolio?

10. What is the portfolio composition (i.e., what are the weights for the nine ETFs)?

Consider the simple case where short sales are NOT allowed and no more than 50% and no less than 5% of the portfolio is invested in any ETF. Use Excel Solver to find the Market Portfolio if the risk-free rate is 0.1250%/month (1.5%/year).

11.  What is the expected portfolio return for this portfolio?

12.  What is the portfolio standard deviation for this portfolio?

13.  What is the portfolio composition (i.e., what are the weights for the nine ETFs)?

14.  What is the maximum Sharpe ratio?