CHAPTER 6: EFFICIENT DIVERSIFICATION

PROBLEM SETS

Use the following data to answer questions 8-12.

A fund manager is considering three managed funds. The first is a share fund, the second is a long-term
government and corporate bond fund, and the third is a cash fund that yields a rate of 5.5%. The
probability distributions of the risky funds are:

Expected Return Standard Deviation

Stock fund (S) 15% 32%
Stock fund (B) 9% 23%

The correlation between the fund returns is 0.15

8.* Tabulate and draw the investment opportunity set of the two risky funds. Use investment
proportions for the share fund of 0 to 100% in increments of 20%. What expected return and
standard deviation does your graph show for the minimum-variance portfolio?

The parameters of the opportunity set are:

E(rS) = 15%, E(rB) = 9%, S = 32%, B = 23%,  = 0.15, rf = 5.5%
Cov(rS, rB) = SB = 0.15 x 32% x 23% = 110.4%2

E(rp) = ws x E(rs) + wb x E(rb)

ws = 0 and wb = 1.0:
E(rp) = 0 x 15% + 1.0 x 9% = 9%
p = [(02  322) + (1.02  232) + (2  0  1.0  110.4)]1/2 = 23%

ws = 0.2 and wb = 0.8:

E(rp) = 0.2 x 15% + 0.8 x 9% = 10.2%
p = [(0.22  322) + (0.82  232) + (2  0.2  0.8  110.4)]1/2 = 20.37%

ws = 0.4 and wb = 0.6:

E(rp) = 0.4 x 15% + 0.6 x 9% = 11.4%
p = [(0.42  322) + (0.62  232) + (2  0.4  0.6  110.4)]1/2 = 20.18%

ws = 0.6 and wb = 0.4:

E(rp) = 0.6 x 15% + 0.4 x 9% = 12.6%
p = [(0.62  322) + (0.42  232) + (2  0.6  0.4  110.4)]1/2 = 22.5%

ws = 0.8 and wb = 0.2:

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 E(rp) = 0.8 x 15% + 0.2 x 9% = 13.8%
p = [(0.82  322) + (0.22  232) + (2  0.8  0.2  110.4)]1/2 = 26.68%

ws = 1.0 and wb = 0:
E(rp) = 1.0 x 15% + 0 x 9% = 15%
p = [(1.02  322) + (02  232) + (2  1.0  0  110.4)]1/2 = 32%

The minimum-variance portfolio proportions are:

wMin(B) = 0.6858

The mean and standard deviation of the minimum variance portfolio are:
E(rMin) = (0.3142  15%) + (0.6858  9%) = 10.89%

= [(0.31422  1024) + (0.68582  529) + (2  0.3142  0.6858  110.4)]1/2

= 19.94%

Expected. Standard
% in shares % in bonds
return deviation
00.00 100.00 9.00 23.00
20.00 80.00 10.20 20.37
31.42 68.58 10.89 19.94 Minimum variance
40.00 60.00 11.40 20.18
60.00 40.00 12.60 22.50
80.00 20.00 13.80 26.68
100.00 00.00 15.00 32.00

9.* Draw a tangent from the risk-free rate to the opportunity set. What does your graph show for the
expected return and standard deviation of the optimal risky portfolio?

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 The graph approximates the
points:
E(r) 
Tangency portfolio 12.88 23.34
% %

10.* What is the reward-to-volatility ratio of the best feasible CAL?

The reward-to-variability ratio of the optimal CAL (using the tangency portfolio) is:

11.* Suppose now that your portfolio must yield an expected return of 12% and be efficient, that is, on
the best feasible CAL.

a. What is the standard deviation of your portfolio?

If you require that your portfolio yield an expected return of 12%, then you can find the
corresponding standard deviation from the optimal CAL.
The equation for the CAL using the tangency portfolio is:

Setting E(rc) equal to 12% yields a standard deviation of: 20.56%

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 b. What is the proportion invested in the T-bill fund and each of the two risky funds?

To find the proportion invested in the T-bill fund, remember that the mean of the
complete portfolio (i.e., 12%) is an average of the T-bill rate and the optimal combination
of shares and bonds (P).
Let y be the proportion invested in the portfolio P. The mean of any portfolio along the
optimal CAL is:
E(rC) = (l  y)rf + yE(rP)
12 = 5.5(1-y) + 12.88y
Solving: y = 0.8808 and (1  y) = 0.1192 (the proportion invested in the T-bill fund)

The weights of stock and bond in the optimal risky portfolio are given as follows:
If ws is the weight of stock, we get:
ws x 15% + (1-ws) x 9% = 12.88%
15ws + 9 – 9ws = 12.88
ws = 0.6466
wb = 1-0.6466 = 0.3534
To find the proportions invested in each of the funds, multiply 0.8808 by the respective
proportions of stocks and bonds in the optimal risky portfolio:
Proportion of shares in complete portfolio = 0.8808  0.6466 = 0.5695
Proportion of bonds in complete portfolio = 0.8808  0.3534 = 0.3133

12.* If you were to use only the two risky funds, and still require an expected return of 12%, what
would be the investment proportions of your portfolio be? Compare its standard deviation to that
of the optimal portfolio in question 11. What do you conclude?

Using only the share and bond funds to achieve a mean of 12% we solve:
12 = 15wS + 9(1 − wS) = 9 + 6wS wS = 0.5 and wb = 0.5

Investing 50% in shares and 50% in bonds yields a mean of 12% and standard deviation of:
P = [(0.502  322) + (0.502  232) + (2  0.50  0.50  110.4)] 1/2 = 21.06%
The efficient portfolio with the same mean of 12% has a standard deviation of only 20.56%.
Using the CAL reduces the standard deviation by 0.5 percentage points.

13.* Shares offer an expected rate of return of 10%, with standard deviation of 20% and gold offers an
expected return of 5% with a standard deviation of 25%.

a. In light of the apparent inferiority of gold with respect to both mean return and volatility, would
anyone hold gold? If so, demonstrate graphically why one would do so.

Although it appears that gold is dominated by shares, gold can still be an attractive
diversification asset. If the correlation between gold and shares is sufficiently low, gold will
be held as a component in the optimal portfolio.

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 b. How would you answer (a) if the correlation coefficient between gold and shares were 1.0? Draw a
graph illustrating why one would or would not hold gold. Could these expected returns, standard
deviations, and correlation represent an equilibrium for the security market?

If gold had a perfectly positive correlation with shares, gold would not be a part of efficient
portfolios. The set of risk/return combinations of shares and gold would plot as a straight line
with a negative slope. (See the following graph.) The graph shows that the share-only
portfolio dominates any portfolio containing gold. This cannot be an equilibrium; the price of
gold must fall and its expected return must rise.

12

10 Stocks
Expected Return (%)

6
Gold

0
0 5 10 15 20 25 30

Standard Deviation (%)

14.* Suppose that many shares are traded in the market and that is possible to borrow at the risk-free
rate, rf. The characteristics of two of the shares are as follows:

Share Expected return Standard deviation

A 8% 40%
B 13 60
Correlation = -1

Could the equilibrium rf be greater than 10%? (Hint: Can a particular share portfolio be substituted
for the risk-free rate asset?)

Create a risk-free portfolio (with zero standard deviation) consisting of only shares A and B.
Variance of portfolio = wA2A2 + wB2B2 + 2wAwBρAB where ρ = correlation = -1
= wA2A2 + wB2B2 - 2wAwBAB
= (wAA  wBB)2
where wA = proportion invested in share A
wB = proportion invested in share B = (1 – wA )
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 To create a risk-free portfolio, set the variance to zero.
0 = (wAA  wBB)2 0
0 = 40wA  [60  (1 – wA )]  wA = 0.60
The expected rate of return for this risk-free portfolio is:
E(r) = (0.60 ) + (0.40 13) = 10.0%
Therefore, the risk-free rate must also be 10.0%

15. Assume expected returns and standard deviations for all securities, as well as the risk-free rate for
lending and borrowing, are known. Will investors arrive at the same optimal risky portfolio?
Explain.

If the lending and borrowing rates are equal and there are no other constraints on portfolio
choice, then optimal risky portfolios of all investors will be identical. However, if the
borrowing and lending rates are not equal, then borrowers (who are relatively risk averse)
and lenders (who are relatively risk tolerant) will have different optimal risky portfolios.

18. A project has a 0.7 chance of doubling your investment in a year and a 0.3 chance of halving your
investment in a year. What is the standard deviation of the rate of return on this investment?

The probability distribution is:

Probabilit Rate of return
y
0.7 100%
0.3 -50%

Expected return = (0.7  100%) + 0.3  (−50%) = 55%

Variance = [0.7  (100 − 55)2] + [0.3  (−50 − 55)2] = 4725%2
Standard deviation = = 68.74%

CFA Problems
2. George Stephenson’s current portfolio of $2.0 million is invested as follows:

Summary of Stephenson’s current portfolio

Value Per cent of Expected annual Annual standard
total return deviation
Short-term bonds $200,000 10% 4.6% 1.6%
Domestic large-cap equities $600,000 30% 12.4% 19.5%
Domestic small-cap equities $1,200,00 60% 16.0% 29.9%
0

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Total portfolio $2,000,00 100% 13.8% 23.1%
0

Stephenson expects to receive an additional $2.0 million soon and plans to invest the entire amount
in an index fund that best complements the current portfolio. Stephanie Wright, CFA, is evaluating
the four index funds shown in the following table for their ability to produce a portfolio that will
meet two criteria relative to the current portfolio:
(1) Maintain or enhance expected return and
(2) maintain or reduce volatility.

Each fund is invested in an asset class that is not substantially represented in the current portfolio.

Index fund characteristics

Index fund Expected annual Expected annual Correlation of returns
return % standard deviation % with current portfolio
Fund A 15 25 +0.80
Fund B 11 22 +0.60
Fund C 16 25 +0.90
Fund D 14 22 +0.65

State which fund Wright should recommend to Stephenson. Justify your choice by describing how
your chosen fund meets both of Stephenson’s criteria. No calculations are required.

Fund D represents the single best addition to complement Harris’s current portfolio, given his
selection criteria. First, Fund D’s expected return (14%) has the potential to increase the
portfolio’s return somewhat. Second, Fund D’s relatively low correlation with his current
portfolio (+0.65) indicates that Fund D will provide greater diversification benefits than any of
the other alternatives except Fund B. The result of adding Fund D should be a portfolio with
approximately the same expected return and somewhat lower volatility compared to the
original portfolio.

The other three funds have shortcomings in terms of either expected return enhancement or
volatility reduction through diversification benefits. Fund A offers the potential for increasing
the portfolio’s return, but is too highly correlated to provide substantial volatility reduction
benefits through diversification. Fund B provides substantial volatility reduction through
diversification benefits, but is expected to generate a return well below the current portfolio’s
return. Fund C has the greatest potential to increase the portfolio’s return, but is too highly
correlated to provide substantial volatility reduction benefits through diversification.