Portfolio Optimization Questions

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Please find the detailed solutions in the attached word document and excel file. Attaching the documents, since plain text would not support the equations and the calculations.

1. Evaluate whether the following statements are true or false.
a) Even if a risky security has a return lower than the risk-free rate, this security could be held for diversification purposes. - True (For example, Gold is considered a negative beta investment during times of stock market crashes)

b) The Glass-Steagall Act of 1933 separated commercial banking from investment banking. - True

c) If returns on two stocks are perfectly positively correlated, you can build a riskless portfolio with those stocks when short-selling is not allowed. - False

d) A risk-free security has a variance of zero. - True

e) A security with a beta of zero is risk free. - True

f) The CAPM implies that investors demand high returns for holding securities with low betas. - False

g) If a stock lies above the securities market line, it is overvalued. - False

h) There is an overwhelming majority of evidence against market efficiency: if you find a profitable trading strategy, you immediately tell the world how to trade. - True

i) The small firm in January effect is strongest at the beginning of the month. - False

j) When a risk-free asset is available, the minimum variance portfolio is the optimal portfolio for all risk-averse investors. - False

2. Consider the following scenario analysis involving asset A and asset B:

Economic Condition Probability Return on X Return on Y
Boom 0.1 30% 12%
Accelerated Growth 0.2 20% 10%
Normal Growth 0.4 15% 9%
Slowdown 0.2 10% 8%
Recession 0.1 -50% -4%

a) Compute the expected returns and the standard deviation of returns for both assets. Then compute the correlation coefficient between the returns on the two assets.

E(RX) = (0.1*30%)+(0.2*20%)+(0.4*15%)+(0.2*10%)+(0.1*-50%)
= 10%

E(RY) = (0.1*12%)+(0.2*10%)+(0.4*9%)+(0.2*8%)+(0.1*-4%)
= 8%

σ(RX) =sqrt( 0.1*(30%-10%)2+0.2*(20%-10%)2+0.4*(15%-10%)2+0.2*(10%-10%)2+0.1*(-50%-10%)2)
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