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Problem 4: ( solve part B and C) (a) Suppose that there are many stocks in the security market and that the characteristics of Stocks

Problem 4: ( solve part B and C)

(a) Suppose that there are many stocks in the security market and that the characteristics of Stocks A and B are given as follows

Stock

Expected Return

Standard Deviation

A

10%

5%

B

15%

10%

Correlation = -1

Suppose that it is possible to borrow at the risk-free rate, rf. What must be the value of the risk-free rate? Explain.

HINT!!! The stocks are perfectly negatively correlated.

(b) Calculate the expected return and standard deviation of an equally weighted portfolio of Stock A, Stock B and the risk-free asset.

(c) What is the optimal portfolio? Assume the investors risk aversion coefficient is given by A=4. Provide all the relevant portfolio weights for all three assets. The utility function is given below. HINT: The formula sheet contains a formula for the optimal risky portfolio for the special case of two risky assets.

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