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Problem Set 5

To get the full credit, you would need to cover Q1 and Q2 (a, b, c and d). There is no allowance
for half-credit for this problem set.

Q1 (Essential to cover)
The risk free rate is 4% and the following data is given about assets X and Z:
Asset E(r)
X 7% 20%
Z 16% 30%
(a) What are the Sharpe ratios of the two risky assets?
(b) Show how you can dominate asset X using a portfolio that combines asset Z and the risk free
asset.
(c) Show how you can dominate a portfolio with equal weights in asset X and the risk-free asset
using a portfolio that combines asset Z and the risk free asset.
(d) Show (in general) how you can dominate any portfolio combining asset X and the risk-free
asset using a portfolio that combines asset Z and the risk-free asset.
Hint: by general, I mean you assume any general fraction (like yX) of wealth in asset X. And
then show how to design a portfolio combining asset Z (with the fraction yZ of wealth in asset Z)
and the risk-free asset which will dominate the portfolio of asset X and the risk-free rate. So
essentially you will need to show the relationship between yZ of the DOMINATING portfolio and
yX of the DOMINATED portfolio.

Q2 (Essential to cover a, b, c, d)
Suppose that the risk-free rate is 3% and that the corresponding optimal risky portfolio has an
expected return of 15% and a standard deviation of 20%. Consider an investor with preferences
represented by the utility function U = E(r) 0.5A2, where A = 2.
(a) What fraction of her wealth should she invest in the risky portfolio?
(b) Should she invest more or less fraction of her wealth in the optimal risky portfolio if she is
more risk-averse? Why?
(c) Should she invest more or less fraction of her wealth in the optimal risky portfolio if the
optimal risky portfolio offers a higher expected return (but the same standard deviation)? Why?
(d) If the risk-free rate is higher, what would you expect the optimal risky portfolio to differ from
the current one (for 3% risk-free rate) in terms of expected return and standard deviation?
(e) Now suppose that the investor faces a higher risk-free rate when borrowing (because you are
facing more borrowing constraints than the government, or people wont allow you to borrow at
the same rate as the government). Specifically, the investor may lend at a risk-free rate of 3% but
has to borrow at a risk-free rate of 5%. Assume for simplicity that the optimal risky portfolio is
the same for either 3% risk-free rate or 5% risk-free rate, i.e., with an expected return of 15% and
a standard deviation of 20% (this should not be the case in reality, as you will find out in
question (d)). What fraction of her wealth should the investor now put in the risky portfolio?
Hint: The risk-free rate of 3% will imply a fraction y1 of wealth invested in the optimal risky
portfolio. The risk-free rate of 5% will imply another fraction y2 of wealth invested in the
optimal risky portfolio. However, 3% is only available for the investor to lend (so she cannot
borrow to invest more than her wealth to invest in the optimal risky portfolio). If she wants to
borrow to invest more than her wealth to invest in the optimal risky portfolio, she will have to go
with 5% risk-free rate (but she wont be able to lend at 5% rate).
The key here is: you would need to understand what weights in the optimal risky portfolio mean
she will lend, and what weights mean she will borrow.
(f) What is the expected return and standard deviation of the portfolio that you found in (e)?
Selected end-of-chapter questions (Optional)
BKM chapter 6: Q1-3, Q21
BKM chapter 7: Q16

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