Assignment 3 FIN 310 by prof. Hanh Le

Assignment 3

FIN 310

Due: Friday April 8

Read the following instructions carefully. Failure to follow these instructions

will result in points being subtracted from your grade:

(i) Write your answers in a separate clean sheet. Do not write on this document.

(ii) If you work in a group, hand in only one submission (not separate submissions as we

have done so far).

(iii) Write the names of all group members on your submission.

(iv) Staple all answer sheets together.

ASSIGNMENT STARTS HERE. ANSWER THE THREE QUESTIONS

BELOW

1. Here are some characteristics of two securities:

Security 1

E

(

R

1

) =

:

10

2

1

=

:

0025

 

 

E

(

R

2

) =

:

16

2

2

=

:

0064

Answer the following questions:

(a) Suppose the investor can only hold a single stock.

(i) Which security should she choose if she wants to maximize expected returns

only?

(ii) Which security should she choose if she wants to minimize risk only?

(b) Suppose the correlation of returns is -1.0, what fraction of the investor’s net

worth should be held in security 1 and in security 2 in order to produce a zero

risk portfolio?

(c) What is the expected return on the portfolio in (c)? How does this compare

with the riskless return on Treasury Bills of 10%? Would an investor who is risk

averse and likes high expected return want to invest in Treasury Bills?

2. Given the following information,

R

f

=

:

06,

E

(

R

M

) =

:

12,

M

=

:

15,where

E

(

R

M

) is

expected market return and

M

is volatility of market return, answer the following

questions.

(a) What is the equilibrium expected return on a risky asset with a

of 1.2? With

a

of .6?

(b) What is the

of a security with an equilibrium expected return of .03?

(c) Is it possible in equilibrium for the expected return on a risky security to be less

than the risk-free rate? Explain. (Hint: look at part (b))

3. Consider the following two equations:

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