Question

1a) According to the CAPM, the market portfolio should be the portfolio with the highest Sharpe ratio. Explain in fewer than five sentences

1b) Suppose you are an asset manager who is designing an optimal portfolio for your client. Explain each of the following questions in fewer than five sentences.

i) What are the three steps in selecting the optimal portfolio?

ii) Now suppose the CAPM holds. How will your optimal portfolio selection change?.

Answer 1

1.a)

The Sharpe ratio is the average return earned in excess of the risk-free rate per unit of volatility or total risk. Volatility is a measure of the price fluctuations of an asset or portfolio.

Subtracting the risk-free rate from the mean return allows an investor to better isolate the profits associated with risk-taking activities. The risk-free rate of return is the return on an investment with zero risk, meaning it's the return investors could expect for taking no risk. The yield for a U.S. Treasury bond, for example, could be used as the risk-free rate.

Generally, the greater the value of the Sharpe ratio, the more attractive the risk-adjusted return.

1.b

i)

STEPS FOR OPTIMAL PORTFOLIO SELCTION ARE

1. DEFINE OBJECTIVES

2.SET OUT ALL THE PORTFOLIO ALTERNATIVES

3. CHOOSE THE BEST ALTERNATIVE AND REVIEW PERIODICALLY

Portfolio optimization is the process of selecting the best portfolio (asset distribution), out of the set of all portfolios being considered, according to some objective. The objective typically maximizes factors such as expected return, and minimizes costs like financial risk. Factors being considered may range from tangible (such as assets, liabilities, earnings or other fundamentals) to intangible (such as selective divestment).

ii)

The proper goal of portfolio construction would be to generate a portfolio that provides the highest return and the lowest risk. Such a portfolio would be known as the optimal portfolio. The process of finding the optimal portfolio is described as portfolio selection.

the change in portofolio will takes place when there is a change in optimal portfolio that is current portfolio is not available on efficient frontier instead some other portfolio has taken place instead of it which provides better opportunities than the optimal one , in such a case optimal portfolio wil change