PROBLEM SET 5

1) The risk free rate is 4% and the following data is given about assets X and
Z:
Asset
X
Z

E(r)
7%
16%

20%
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.
2) Suppose that the risk-free rate is 3% and that the 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) 12 2 2 .
(a) What fraction of her wealth should she invest in the risky portfolio?
(b) Now suppose that the investor faces a higher risk-free rate when borrowing. Specifically, the investor may lend at a risk-free rate of 3% but
borrow at a risk-free rate of 5%. Assume for simplicity that the optimal
risky portfolio is not affected. What fraction of her wealth should the
investor now put in the risky portfolio?
(c) What is the expected return and standard deviation of the portfolio
that you found in (b)?

3) Consider a market that consists of only two assets, A and B. The riskfree rate, rf , is 3% and the expected return of the market, E(rM ), is 13%.
Some properties of the individual assets are given in the table below (with
denoting the corrleation coefficient and w denoting the assets weight in
the market portfolio):
Asset
A
B

w
0.4
0.6

2
0.04
0.25

0.2
0.5

i,A
1
0.3

i,B
0.3
1

(a) What is the market variance?

(b) What are the covariances with the market of the two assets?
(c) Recall the CAPM equation we derived at the end of lecture 5:
E(ri ) = rf +

Cov(ri , rM )
[E(rM ) rf ]
2
M

We typically refer to the risk measure i =

Cov(ri , rM )
2
M

as the assets (CAPM) . What are the CAPM of the two assets?
(d) What is the CAPM of the market portfolio?
(e) What are the reward-to-risk ratios of the two assets?
(f) What are the contributions of each asset to the market excess return,
E(rM ) rf ?
2
?
(g) What are the contributions of each asset to the market variance, M

(h) What are the contributions of each asset to the reward-to-risk ratio of
E(rM ) rf
the market,
?
2
M
(i) Suppose you had found that the contribution of asset A to reward-torisk ratio of the market was 1 and that the contribution of asset B to
the same ratio was 0.8. How could you construct a portfolio that beats
the market? Could this be an equilibrium?