Question

You will function as employees within a finance department of XYZ Inc. Your goal is to propose changes to the way XYZ manages its money. Currently, the CFO maintains all of XYZ's cash holdings at a local bank. You will propose changes to this policy by developing a portfolio made up of T-Bills, STRIPS, and Bonds that optimizes the return for XYZ under constraint.

Suppose XYZ has average monthly cash holdings of $15 million, revenue of $8 million, and expenses of $7.5 million. Since XYZ still requires some liquidity, it is your responsibility to propose a portfolio that includes a mix bank holdings and fixed income securities. Create a portfolio, analyze its returns compared to the current policy, discuss any inherent risks (interest rate and liquidity).

i need help please

Answer 1

The answer

The idea of an optimal portfolio theory assumes that investors focus their efforts on minimizing risk while also striving to attain the highest possible return. Investors will act rationally within these parameters, and that they will always make decisions with the goal of maximizing return for a given acceptable level of risk.

It will show that it is possible for different portfolios to have different levels of risk and return. This means that individual investors should determine how much risk they are willing to take on, and then they can allocate or diversify their portfolios according to the results of that decision.

So in a finance department to construct an optimal portfolio it is imperative with more than one risky asset.
we need to have a combination of expected variance return that can be indicated which will indicate a combination line which is linear.Suppose an example with two riskly assets like D and E the formula for portfolio return can be given as :

Where Erp= Expected Return

W_{d =Weights for first asset ie mix bank holdings}

_{Erd = Expected return from the 1st asset}

_{We =Weights for the 2nd Asset ie fixed income securities}

_{Ere=Expected return from the 2nd asset.}

_{The second formula is the standard deviation of the portfolios which are mix bank holdings and fixed income securities which analyses the risk a particular portfolio is having}

The following are the inherent risks which can defined as follows are

Interest Risk =This is the risk which can happen due to adverse fluctuations in market interest rates for the fixed income securities which can adversely affect the value of portfolio.Followings may be briefly the causes

a.A decline in the PV of cash flows

b A growth in the PV of the future expected returns.

c.The counterparty risk which may arise in case of an option user causing loss to the investor.

Liquidity Risk=This risk can arise from the potential necessity to sell any financial instrument while applying a discount to the market value whenever the financial instrument needs to be sold out at the shortest possible time period .This can arise in case of mix bank holdings because of lack of demand and supply in the market.