In: Finance
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?
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 |