Question

In: Finance

An investor can design a risky portfolio based on two stocks, A and B. Stock A...

An investor can design a risky portfolio based on two stocks, A and B. Stock A has an expected return of 21% and a standard deviation of return of 39%. Stock B has an expected return of 14% and a standard deviation of return of 20%. The correlation coefficient between the returns of A and B is 0.4. The risk-free rate of return is 5%.

What is the REWARD to VARIABILITY Ratio of the Optimal Portfolio?

Solutions

Expert Solution

To find the fraction of wealth to invest in Stock A that will result in the risky portfolio with maximum Sharpe ratio the following formula to determine the weight of Stock A in risky portfolio should be used

Where
Stock A E[R(d)]= 21.00%
Stock B E[R(e)]= 14.00%
Stock A Stdev[R(d)]= 39.00%
Stock B Stdev[R(e)]= 20.00%
Var[R(d)]= 0.15210
Var[R(e)]= 0.04000
T bill Rf= 5.00%
Correl Corr(Re,Rd)= 0.4
Covar Cov(Re,Rd)= 0.0312
Stock A Therefore W(*d)= 0.2923
Stock B W(*e)=(1-W(*d))= 0.7077
Expected return of risky portfolio= 16.05%
Risky portfolio std dev= 21.43%
Sharpe ratio= (Port. Exp. Return-Risk free rate)/(Port. Std. Dev) =(0.1605-0.05)/0.2143 =0.5156
Where
Var = std dev^2
Covariance = Correlation* Std dev (r)*Std dev (d)
Expected return of the risky portfolio = E[R(d)]*W(*d)+E[R(e)]*W(*e)
Risky portfolio standard deviation =( w2A*σ2(RA)+w2B*σ2(RB)+2*(wA)*(wB)*Cor(RA,RB)*σ(RA)*σ(RB))^0.5

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