9.

Suppose you plan to form your overall investment portfolio in two steps:

STEP 1: Choose a portfolio of stocks with a zero position in the risk-free asset.

STEP 2: Allocate your money between the portfolio from Step 1 and the risk-free asset.

Suppose you can borrow and lend as much as you want at the risk-free rate in Step 2.

Let Erp be the expected return of the Step 1 portfolio.

Let Var(rp) be the variance of the return of the Step 1 portfolio. Let rf be the risk-free rate.

How will you form the Step 1 Portfolio?

1. Set the Step 1 portfolio to maximize Erp
2. SettheStep1portfoliotominimizeVar(rp)
3. Set the Step 1 portfolio to maximize Erp - Var(rp)
4. Set the Step 1 portfolio to maximize the ratio Erp/Var(rp)
5. Set the Step 1 portfolio to maximize the ratio (Erp- rf)/Var(rp)
6. None of the above.