Q3 (Essential to cover) The optimal risky portfolio P* has an expected return of 12.5% and a

standard deviation of 22%. The current risk-free rate in the market is 1.5%.

a. Draw the capital allocation line. What is the slope of this line and what does it represent?

Suppose that separation theorem holds, and all investors invest along a common capital

allocation line. Consider two different investors. Aggressive investor A holds an optimal

complete portfolio which has a standard deviation of 25%. Conservative investor C holds an

optimal complete portfolio with a standard deviation of 14%.

b. What is the Sharpe Ratio of Investor A and Investor C's optimal complete portfolio?

c. What is the expected return of Investor A and Investor C's optimal complete portfolio?

d. What is allocation to risky assets y* for Investor A and Investor C's optimal complete

portfolio?

e. Derive the implied risk aversion coefficient for Investor A and Investor C.

f. Explain why these results are a demonstration of separation theorem.