You are discussing your retirement plan with Dan Ervin when he mentions that Sarah Brown, a representative from Skandla Financial Services, is visiting West Coast Yachts today. You decide that you should meet with Sarah, so Dan sets up an appointment for you later in the day.
When you sit down with Sarah, she discusses the various investment options available in the company’s retirement account. You mention to Sarah that you researched West Coast Yachts before you accepted your new job. You are confident in management’s ability to lead the company. Analysis of the company has led to your belief that the company is growing and will achieve a greater market share in the future. Given these considerations, you are leaning toward investing 100 per cent of your retirement account in West Coast Yachts.
Assume the risk-free rate is the return on a 30-day T-bill. The correlation between the Skandla bond fund and large-cap equity fund is 0.27.
1. Considering the effects of diversification, how should Sarah respond to the suggestion that you invest 100 per cent of your retirement account in West Coast Yachts?
2. Sarah’s response to investing your retirement account entirely in West Coast Yachts has convinced you that this may not be the best alternative. You now consider that a 100 per cent investment in the bond fund may be the best alternative. Is it?
3. Using the returns for the Skandla Large-Cap Equity Fund and the Skandla Bond Fund, graph the opportunity set of feasible portfolios.
4. After examining the opportunity set, you notice that you can invest in a portfolio consisting of the bond fund and the large-cap equity fund that will have exactly the same standard deviation as the bond fund. This portfolio will also have a greater expected return. What are the portfolio weights and expected return of this portfolio?
5. Examining the opportunity set, notice there is a portfolio that has the lowest standard deviation. This is the minimum variance portfolio. What are the portfolio weights, expected return, and standard deviation of this portfolio? Why is the minimum variance portfolio important?
6. A measure of risk-adjusted performance that is often used is the Sharpe ratio. The Sharpe ratio is calculated as the risk premium of an asset divided by its standard deviation. The portfolio with the highest possible Sharpe ratio on the opportunity set is called the Sharpe optimal portfolio. What are the portfolio weights, expected return, and standard deviation of the Sharpe optimal portfolio? How does the Sharpe ratio of this portfolio compare to the Sharpe ratios of the bond fund and the large-cap equity fund? Do you see a connection between the Sharpe optimal portfolio and the CAPM?