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ICAN STRATEGIC FINANCIAL MANAGEMENT PROFESSIONAL EXAMINATION WEEK 7 QUESTIONS TOPIC: PORTFOLIO THEORY & CAPM Kindly go through chapter 5 (Part 2) in the video lecture before you attempt the questions because the topic have been simplified and analyzed for easy understanding. REVIEW QUESTIONS 1a. Discuss the benefits of using the Capital Asset Pricing Model to analyse investment portfolios compared to earlier formulations of portfolio theory such as the mean-variance and capital market line methods b. Explain the difference between systematic and unsystematic risk in relation to portfolio theory and the capital asset pricing model STARRY GOLD ACADEMY +2348023428420, +2347038174484, [email protected] , www.starrygoldacademy.com Page 1 2. You manage a risky portfolio with an expected rate of return of 17% and a standard deviation of 27%. The Treasury-bill rate is 7%. One of your clients Alhaji Yahaya chooses to invest 70% of a portfolio in your fund and 30% in a T-bill money market fund. a. What will be the expected value and standard deviation of the rate of return on your client’s portfolio? b. Suppose Alhaji decides to invest a proportion y of the total investment budget so that the overall portfolio will have an expected rate of return of 15%. i. What is the proportion y? ii. Further suppose that your risky portfolio includes the following investments in the given proportions: Stock A (27%), Stock B (33%), and Stock C (40%). What are your client’s investment proportions in your three stocks and the T-bill fund? c. Now suppose that your client prefers to invest in your fund a proportion y that maximizes the expected return on the overall portfolio subject to the constraint that the overall portfolio’s standard deviation will not exceed 20%. i. What is the investment proportion, y? STARRY GOLD ACADEMY +2348023428420, +2347038174484, [email protected] , www.starrygoldacademy.com Page 2 ii. What is the expected rate of return on the overall portfolio? 3. A portfolio consists of two assets, the expected returns and standard deviations of returns of which are listed in the table below: Expected Return Standard Deviation Asset 1 8% 16% Asset 2 10% 20% (a) Calculate: (i) The expected return for a portfolio which is equally weighted between the two assets. (ii) The correlation coefficient for the two-asset portfolio, assuming that the covariance is 32. (iii) The variance of returns for the equally weighted portfolio, assuming a covariance of 32. (iv) The standard deviation of returns for the equally weighted portfolio. (b) Calculate the simple weighted standard deviation of the portfolio and comment on the scale of risk reduction. STARRY GOLD ACADEMY +2348023428420, +2347038174484, [email protected] , www.starrygoldacademy.com Page 3 (c) In principle, the two-asset model of portfolio risk can be applied to portfolios which include far greater numbers of assets. Explain the implications of this approach for the understanding of portfolio risk and discuss the practical problems of applying the model in this fashion STARRY GOLD ACADEMY +2348023428420, +2347038174484, [email protected] , www.starrygoldacademy.com Page 4
