In: Finance
Greta has risk aversion of A = 3 when applied to return
on wealth over a one-year horizon. She is pondering two portfolios,
the S&P 500 and a hedge fund, as well as a number of one-year
strategies. (All rates are annual and continuously compounded.) The
S&P 500 risk premium is estimated at 5% per year, with a
standard deviation of 17%. The hedge fund risk premium is estimated
at 10% with a standard deviation of 32%. The returns on both of
these portfolios in any particular year are uncorrelated with its
own returns in other years. They are also uncorrelated with the
returns of the other portfolio in other years. The hedge fund
claims the correlation coefficient between the annual return on the
S&P 500 and the hedge fund return in the same year is
zero, but Greta is not fully convinced by this claim.
What should be Greta’s capital allocation?
S&P= ___%
Hedge= ____%
Risk-Free asset= ____%