Chapter 4 Part I IPM (BMA Ch.

5 e 6)
Summary 5
 The economy’s equilibrium level of real interest rates depends on the willingness of
households to save, as reflected in the supply curve of funds, and on the expected
profitability of business investment in plant, equipment, and inventories, as reflected
in the demand curve for funds. It depends also on government fiscal and monetary
policy.
 The nominal rate of interest is the equilibrium real rate plus the expected rate of
inflation. In general, we can directly observe only nominal interest rates; from them,
we must infer expected real rates, using inflation forecasts. Assets with guaranteed
nominal interest rates are risky in real terms because the future inflation rate is
uncertain.
 The equilibrium expected rate of return on any security is the sum of the equilibrium
real rate of interest, the expected rate of inflation, and a security-specific risk
premium.
 Investors face a trade-off between risk and expected return. Historical data confirm
our intuition that assets with low degrees of risk should provide lower returns on
average than do those of higher risk.
 Historical rates of return over the last century in other countries suggest the U.S.
history of stock returns is not an outlier compared to other countries.
 Historical returns on stocks exhibit somewhat more frequent large deviations from the
mean than would be predicted from a normal distribution. However, the discrepancies
from the normal distribution tend to be minor and inconsistent across various
measures of tail risk, and have declined in recent years. The lower partial standard
deviation (LPSD), skew, and kurtosis of the actual distribution quantify the deviation
from normality.
 Widely used measures of tail risk are value at risk (VaR) and expected shortfall or,
equivalently, conditional tail expectations. VaR measures the loss that will be
exceeded with a specified probability such as 1% or 5%. Expected shortfall (ES)
measures the expected rate of return conditional on the portfolio falling below a
certain value. Thus, 1% ES is the expected value of the outcomes that lie in the bottom
1% of the distribution.
 Investments in risky portfolios do not become safer in the long run. On the contrary,
the longer a risky investment is held, the greater the risk. The basis of the argument
that stocks are safe in the long run is the fact that the probability of an investment
shortfall becomes smaller. However, probability of shortfall is a poor measure of the
safety of an investment because it ignores the magnitude of possible losses.
Summary 6
 Speculation is the undertaking of a risky investment for its risk premium. The risk
premium has to be large enough to compensate a risk-averse investor for the risk of
the investment.
 A fair game is a risky prospect that has a zero risk premium. It will not be undertaken
by a risk-averse investor.
 Investors’ preferences toward the expected return and volatility of a portfolio may be
expressed by a utility function that is higher for higher expected returns and lower for
higher portfolio variances. More risk-averse investors will apply greater penalties for
risk. We can describe these preferences graphically using indifference curves.
 The desirability of a risky portfolio to a risk-averse investor may be summarized by the
certainty equivalent value of the portfolio. The certainty equivalent rate of return is a
value that, if received with certainty, would yield the same utility as the risky portfolio.
 Shifting funds from the risky portfolio to the risk-free asset is the simplest way to
reduce risk. Other methods involve diversification of the risky portfolio and hedging.
We take up these methods in later chapters.
 T-bills provide a perfectly risk-free asset in nominal terms only. Nevertheless, the
standard deviation of real returns on short-term T-bills is small compared to that of
other assets such as long-term bonds and common stocks, so for the purpose of our
analysis we consider T-bills as the risk-free asset. Money market funds hold, in addition
to T-bills, short-term relatively safe obligations such as repurchase agreements or bank
CDs. These entail some default risk, but again, the additional risk is small relative to
most other risky assets. For convenience, we often refer to money market funds as
risk-free assets.
 An investor’s risky portfolio (the risky asset) can be characterized by its reward-to-
volatility or Sharpe ratio, S = [E(rP) − rf ]/σP. This ratio is also the slope of the CAL, the
line that, when graphed, goes from the risk-free asset through the risky asset. All
combinations of the risky asset and the risk-free asset lie on this line. Other things
equal, an investor would prefer a steeper-sloping CAL because that means higher
expected return for any level of risk. If the borrowing rate is greater than the lending
rate, the CAL will be “kinked” at the point of the risky asset.
 The investor’s degree of risk aversion is characterized by the slope of his or her
indifference curve. Indifference curves show, at any level of expected return and risk,
the required risk premium for taking on one additional percentage point of standard
deviation. More risk-averse investors have steeper indifference curves; that is, they
require a greater risk premium for taking on more risk.
 The optimal position, y*, in the risky asset is proportional to the risk premium and
inversely proportional to the variance and degree of risk aversion:

Graphically, this portfolio represents the point at which the indifference curve is tangent to the
CAL.
 A passive investment strategy disregards security analysis, targeting instead the risk-
free asset and a broad portfolio of risky assets such as the S&P 500 stock portfolio. If in
2018 investors took the mean historical return and standard deviation of the S&P 500
as proxies for its expected return and standard deviation, then the values of
outstanding assets would imply a degree of risk aversion of about A = 2.96 for the
average investor. This is in line with other studies, which estimate typical risk aversion
in the range of 2.0 through 4.0.
Questions 5
1. The Fisher equation tells us that the real interest rate approximately equals the
nominal rate minus the inflation rate. Suppose the inflation rate increases from 3% to
5%. Does the Fisher equation imply that this increase will result in a fall in the real rate
of interest? Explain.
2. You’ve just stumbled on a new dataset that enables you to compute historical rates of
return on U.S. stocks all the way back to 1880. What are the advantages and
disadvantages in using these data to help estimate the expected rate of return on U.S.
stocks over the coming year?
3. The Narnian stock market had a rate of return of 45% last year, but the inflation rate
was 30%. What was the real rate of return to Narnian investors?
4. You have $5,000 to invest for the next year and are considering three alternatives:
a. A money market fund with an average maturity of 30 days offering a current
yield of 3% per year.
b. A 1-year savings deposit at a bank offering an interest rate of 4%.
c. A 20-year U.S. Treasury bond offering a yield to maturity of 5% per year. What
role does your forecast of future interest rates play in your decisions?
5. Use Figure 5.1 in the text to analyze the effect of the following on the level of real
interest rates:
a. Businesses become more pessimistic about future demand for their products
and decide to reduce their capital spending.
b. Households are induced to save more because of increased uncertainty about
their future Social Security benefits.
c. The Federal Reserve Board undertakes open-market purchases of U.S.
Treasury securities in order to increase the supply of money.
6. You are considering the choice between investing $50,000 in a conventional 1-year
bank CD offering an interest rate of 5% and a 1-year “Inflation-Plus” CD offering 1.5%
per year plus the rate of inflation.
a. Which is the safer investment?
b. Can you tell which offers the higher expected return?
c. If you expect the rate of inflation to be 3% over the next year, which is the
better investment? Why?
d. If we observe a risk-free nominal interest rate of 5% per year and a risk-free
real rate of 1.5% on inflation-indexed bonds, can we infer that the market’s
expected rate of inflation is 3.5% per year?
7. Suppose your expectations regarding the stock price are as follows:

Use Equations 5.11 and 5.12 to compute the mean and standard deviation of the HPR on
stocks.
 8. Derive the probability distribution of the 1-year HPR on a 30-year U.S. Treasury bond
with an 8% coupon if it is currently selling at par and the probability distribution of its
yield to maturity a year from now is as follows:

For simplicity, assume the entire 8% coupon is paid at the end of the year rather than every 6
months.

9. Determine the standard deviation of a random variable q with the following

10. The continuously compounded annual return on a stock is normally distributed with a
mean of 20% and standard deviation of 30%. With 95.44% confidence, we should
expect its actual return in any particular year to be between which pair of values?
(Hint: Look again at Figure 5.3.)
a. −40.0% and 80.0%
b. -30.0% and 80.0%
c. −20.6% and 60.6%
d. −10.4% and 50.4%
11. Using historical risk premiums from Table 5.5 over the 1927–2018 period as your
guide, what would be your estimate of the expected annual HPR on the Big/Value
portfolio if the current risk-free interest rate is 3%?
12. Visit Professor Kenneth French’s data library Web site:
http://mba.tuck.dartmouth.edu/pages/ faculty/ken.french/data_library.html and
download the monthly returns of “6 portfolios formed on size and book-to-market (2 ×
3).” Choose the value-weighted series for the period from January 1930–December
2018. Split the sample in half and compute the average, SD, skew, and kurtosis for
each of the six portfolios for the two halves. Do the six split-halves statistics suggest to
you that returns come from the same distribution over the entire period?
13. During a period of severe inflation, a bond offered a nominal HPR of 80% per year. The
inflation rate was 70% per year.
a. What was the real HPR on the bond over the year?
b. Compare this real HPR to the approximation rreal ≈ rnom − i.
14. Suppose that the inflation rate is expected to be 3% in the near future. Using the
historical data provided in this chapter, what would be your predictions for:
a. The T-bill rate?
b. The expected rate of return on the Big/Value portfolio?
c. The risk premium on the stock market?
15. An economy is making a rapid recovery from steep recession, and businesses foresee a
need for large amounts of capital investment. Why would this development affect real
interest rates?
 16. You are faced with the probability distribution of the HPR on the stock market index
fund given in Spreadsheet 5.1 of the text. Suppose the price of a put option on a share
of the index fund with exercise price of $110 and time to expiration of 1 year is $12.
a. What is the probability distribution of the HPR on the put option?
b. What is the probability distribution of the HPR on a portfolio consisting of one
share of the index fund and a put option?
c. In what sense does buying the put option constitute a purchase of insurance in
this case?
17. Suppose the risk-free interest rate is 6% per year. You are contemplating investing
$107.55 in a 1-year CD and simultaneously buying a call option on the stock market
index fund with an exercise price of $110 and expiration of 1 year. Using the scenario
analysis of Spreadsheet 5.1, what is the probability distribution of your dollar return at
the end of the year?
18. Consider these long-term investment data:
i. The price of a 10-year $100 face value zero-coupon inflation-indexed
bond is $84.49.
ii. A real-estate property is expected to yield 2% per quarter (nominal)
with a SD of the (effective) quarterly rate of 10%.
b. Compute the annual rate of return on the real (i.e., inflation-indexed) bond.
c. Compute the continuously compounded annual risk premium on the real-
estate investment.
d. Use the formula in footnote 14 and Excel’s Solver or Goal Seek to find the
standard deviation of the continuously compounded annual excess return on
the real-estate investment.
e. What is the probability of loss or shortfall after 10 years?

CFA PROBLEMS Ch. 5

2. Based on the scenarios below, what is the expected return for a portfolio with the
following return profile?

Use the following scenario analysis for Stocks X and Y to answer CFA Problems 3 through 5
(round to the nearest percent).
 3. What are the expected rates of return for Stocks X and Y?
4. What are the standard deviations of returns on Stocks X and Y?
5. Assume that of your $10,000 portfolio, you invest $9,000 in Stock X and $1,000 in
Stock Y. What is the expected return on your portfolio?
6. Probabilities for three states of the economy and probabilities for the returns on a
particular stock in each state are shown in the table below.

What is the probability that the economy will be neutral and the stock will experience poor
performance?

7. An analyst estimates that a stock has the following probabilities of return depending
on the state of the economy:

What is the expected return of the stock?

8.
Questions 6
1. Which of the following choices best completes the following statement? Explain. An
investor with a higher degree of risk aversion, compared to one with a lower degree,
will most prefer investment portfolios
a. with higher risk premiums.
b. that are riskier (with higher standard deviations).
c. with lower Sharpe ratios.
d. with higher Sharpe ratios.
2. Which of the following statements are true? Explain.
a. A lower allocation to the risky portfolio reduces the Sharpe (reward-to-
volatility) ratio.
b. The higher the borrowing rate, the lower the Sharpe ratios of levered
portfolios.
c. With a fixed risk-free rate, doubling the expected return and standard
deviation of the risky portfolio will double the Sharpe ratio.
d. Holding constant the risk premium of the risky portfolio, a higher risk-free rate
will increase the Sharpe ratio of investments with a positive allocation to the
risky asset.
3. What do you think would happen to the equilibrium expected return on stocks if
investors perceived higher volatility in the equity market? Relate your answer to
Equation 6.7.
4. Consider a risky portfolio. The end-of-year cash flow derived from the portfolio will be
either $70,000 or $200,000 with equal probabilities of .5. The alternative risk-free
investment in T-bills pays 6% per year.
a. If you require a risk premium of 8%, how much will you be willing to pay for
the portfolio?
b. Suppose that the portfolio can be purchased for the amount you found in (a).
What will be the expected rate of return on the portfolio?
c. Now suppose that you require a risk premium of 12%. What price are you
willing to pay?
d. Comparing your answers to (a) and (c), what do you conclude about the
relationship between the required risk premium on a portfolio and the price at
which the portfolio will sell?
5. Consider a portfolio that offers an expected rate of return of 12% and a standard
deviation of 18%. T-bills offer a risk-free 7% rate of return. What is the maximum level
of risk aversion for which the risky portfolio is still preferred to T-bills?
6. Draw the indifference curve in the expected return–standard deviation plane
corresponding to a utility level of .05 for an investor with a risk aversion coefficient of
3. (Hint: Choose several possible standard deviations, ranging from 0 to .25, and find
the expected rates of return providing a utility level of .05. Then plot the expected
return–standard deviation points so derived.)
7. Now draw the indifference curve corresponding to a utility level of .05 for an investor
with risk aversion coefficient A = 4. Comparing your answer to Problem 6, what do you
conclude?
8. Draw an indifference curve for a risk-neutral investor providing utility level .05.
9. What must be true about the sign of the risk aversion coefficient, A, for a risk lover?
Draw the indifference curve for a utility level of .05 for a risk lover.
For Problems 10 through 12: Consider historical data showing that the average annual rate of
return on the S&P 500 portfolio over the past 90 years has averaged roughly 8% more than the
Treasury bill return and that the S&P 500 standard deviation has been about 20% per year.
Assume these values are representative of investors’ expectations for future performance and
that the current T-bill rate is 5%.

10. Calculate the expected return and variance of portfolios invested in T-bills and the S&P
500 index with weights as follows:

11. Calculate the utility levels of each portfolio of Problem 10 for an investor with A = 2.
What do you conclude?
12. Repeat Problem 11 for an investor with A = 3. What do you conclude?

Use these inputs for Problems 13 through 19: You manage a risky portfolio with an expected
rate of return of 18% and a standard deviation of 28%. The T-bill rate is 8%.

13. Your client chooses to invest 70% of a portfolio in your fund and 30% in an essentially
risk-free money market fund. What are the expected value and standard deviation of
the rate of return on his portfolio?
14. Suppose that your risky portfolio includes the following investments in the given
proportions:

What are the investment proportions of your client’s overall portfolio, including the position in
T-bills?

15. What is the reward-to-volatility (Sharpe) ratio (S) of your risky portfolio? Your client’s?
16. Draw the CAL of your portfolio on an expected return–standard deviation diagram.
What is the slope of the CAL? Show the position of your client on your fund’s CAL.
17. Suppose that your client decides to invest in your portfolio a proportion y of the total
investment budget so that the overall portfolio will have an expected rate of return of
16%.
a. What is the proportion y?
b. What are your client’s investment proportions in your three stocks and the T-
bill fund?
c. What is the standard deviation of the rate of return on your client’s portfolio?
18. Suppose that your client prefers to invest in your fund a proportion y that maximizes
the expected return on the complete portfolio subject to the constraint that the
complete portfolio’s standard deviation will not exceed 18%.
a. What is the investment proportion, y?
b. What is the expected rate of return on the complete portfolio?
 19. Your client’s degree of risk aversion is A = 3.5.
a. What proportion, y, of the total investment should be invested in your fund?
b. What are the expected value and standard deviation of the rate of return on
your client’s optimized portfolio?
20. Look at the data in Table 6.7 on the average excess return of the U.S. equity market
and the standard deviation of that excess return. Suppose that the U.S. market is your
risky portfolio.
a. If your risk-aversion coefficient is A = 4 and you believe that the entire 1927–
2018 period is representative of future expected performance, what fraction
of your portfolio should be allocated to T-bills and what fraction to equity?
b. What if you believe that the 1973–1995 period is representative?
c. What do you conclude upon comparing your answers to (a) and (b)?
21. Consider the following information about a risky portfolio that you manage and a risk-
free asset: E(rP) = 11%, σP = 15%, rf = 5%.
a. Your client wants to invest a proportion of her total investment budget in your
risky fund to provide an expected rate of return on her overall or complete
portfolio equal to 8%. What proportion should she invest in the risky portfolio,
P, and what proportion in the risk-free asset?
b. What will be the standard deviation of the rate of return on her portfolio?
c. Another client wants the highest return possible subject to the constraint that
you limit his standard deviation to be no more than 12%. Which client is more
risk averse?
22. Investment Management Inc. (IMI) uses the capital market line to make asset
allocation recommendations. IMI derives the following forecasts:
i. Expected return on the market portfolio: 12%
ii. Standard deviation on the market portfolio: 20%
iii. Risk-free rate: 5%

Samuel Johnson seeks IMI’s advice for a portfolio asset allocation. Johnson informs IMI that he
wants the standard deviation of the portfolio to equal half of the standard deviation for the
market portfolio. Using the capital market line, what expected return can IMI provide subject
to Johnson’s risk constraint?

For Problems 23 through 26: Suppose that the borrowing rate that your client faces is 9%.
Assume that the equity market index has an expected return of 13% and standard deviation of
25%, that rf = 5%, and that your fund has the parameters given in Problem 21.

23. Draw a diagram of your client’s CML, accounting for the higher borrowing rate.
Superimpose on it two sets of indifference curves, one for a client who will choose to
borrow and one for a client who will invest in both the index fund and a money market
fund.
24. What is the range of risk aversion for which a client will neither borrow nor lend, that
is, for which y = 1?
25. Solve Problems 23 and 24 for a client who uses your fund rather than an index fund.
26. What is the largest percentage fee that a client who currently is lending (y < 1) will be
willing to pay to invest in your fund? What about a client who is borrowing (y > 1)?
For Problems 27 through 29: You estimate that a passive portfolio, for example, one invested
in a risky portfolio that mimics the S&P 500 stock index, offers an expected rate of return of
13% with a standard deviation of 25%. You manage an active portfolio with expected return
18% and standard deviation 28%. The risk-free rate is 8%.

27. Draw the CML and your funds’ CAL on an expected return–standard deviation diagram.
a. What is the slope of the CML?
b. Characterize in one short paragraph the advantage of your fund over the
passive fund.
28. Your client ponders whether to switch the 70% that is invested in your fund to the
passive portfolio.
a. Explain to your client the disadvantage of the switch.
b. Show him the maximum fee you could charge (as a percentage of the
investment in your fund, deducted at the end of the year) that would leave
him at least as well off investing in your fund as in the passive one. (Hint: The
fee will lower the slope of his CAL by reducing the expected return net of the
fee.)
29. Consider again the client in Problem 19 with A = 3.5.
a. If he chose to invest in the passive portfolio, what proportion, y, would he
select?
b. Is the fee (percentage of the investment in your fund, deducted at the end of
the year) that you can charge to make the client indifferent between your fund
and the passive strategy affected by his capital allocation decision (i.e., his
choice of y)?

CFA PROBLEMS
Use the following data in answering CFA Problems 1–3:

1. On the basis of the utility formula above, which investment would you select if you
were risk averse with A = 4?
2. On the basis of the utility formula above, which investment would you select if you
were risk neutral?
3. The variable (A) in the utility formula represents the:
a. Investor’s return requirement.
b. Investor’s aversion to risk.
c. Certainty equivalent rate of the portfolio.
d. Preference for one unit of return per four units of risk.
Use the following graph to answer CFA Problems 4 and 5.

4. Which indifference curve represents the greatest level of utility that can be achieved
by the investor?
5. Which point designates the optimal portfolio of risky assets?
6. Given $100,000 to invest, what is the expected risk premium in dollars of investing in
equities versus risk-free T-bills on the basis of the following table?

7. The change from a straight to a kinked capital allocation line is a result of the:
a. Reward-to-volatility (Sharpe) ratio increasing.
b. Borrowing rate exceeding the lending rate.
c. Investor’s risk tolerance decreasing.
d. Increase in the portfolio proportion of the risk-free asset.
8. You manage an equity fund with an expected risk premium of 10% and an expected
standard deviation of 14%. The rate on Treasury bills is 6%. Your client chooses to
invest $60,000 of her portfolio in your equity fund and $40,000 in a T-bill money
market fund. What are the expected return and standard deviation of return on your
client’s portfolio?
9. What is the reward-to-volatility (Sharpe) ratio for the equity fund in CFA Problem 8?