Question
Portfolio optimization involves three steps: asset allocation, security selection, and capital allocation. This question is about security selection . To simply the matter, assume your
Portfolio optimization involves three steps: asset allocation, security selection, and capital allocation. This question is about security selection.
To simply the matter, assume your investable universe is two stocks, Pfizer (PFE) and Caterpillar (CAT), and a risk-free asset. PFE has an expected return of 15% with a standard deviation of 15%. CAT has an expected return of 12.5% with a standard deviation of 18%. The correlation of the two stocks is 0.1. The risk-free rate is 10%.
You realize PFE is strictly more preferable than CAT due to higher expected return with lower risk and decide to get lazy on optimization. Say, you decide to allocate the vast majority of your risky portfolio in PFE and put just a little into CAT just to check the diversification box. You decide you want 90% PFE and 10% CAT for your risky portfolio and call it good. What is the Sharpe ratio of this portfolio?
Step by Step Solution
There are 3 Steps involved in it
Step: 1
Get Instant Access to Expert-Tailored Solutions
See step-by-step solutions with expert insights and AI powered tools for academic success
Step: 2
Step: 3
Ace Your Homework with AI
Get the answers you need in no time with our AI-driven, step-by-step assistance
Get Started