Question
Question 1 - Designing a risk-free asset (7+3) Assume you have 2 risky assets: a bond fund & an equity fund. w D bond fund
Question 1 - Designing a risk-free asset (7+3)
Assume you have 2 risky assets: a bond fund & an equity fund.
wD bond fund weight, with expected returns & variance: E(rD) and sD 2
wE stock fund weight, with E(rE) and sE2
sDE covariance between these funds = sD. sE with sD ? sE.
In what proportion do you have to mix these funds to create a risk-free portfolio? What is the risk-free rate in this market?
Question 2 Part I- Diversification & trading strategies: (2+3 points)
a)Suppose there are only 2 stocks x & y in the market and their returns are always related to one another by x=2y+0.05. Can an investor get any benefit from diversification in this market?
b)Can you design a long-short trading strategy in this market that will give you risk free returns? Elucidate.
Question 2 Part II - CAPM: (5 points)
We saw in class that the CAPM relates risk to expected returns for every security in the market, & Risk in CAPM is covariance. Suppose I told you that the relationship between risk and return given by the security market line was linear. That is, for any security x:
E(Rx)=a+b.?Mx.
Use just this information to derive the CAPM equation/formula. (Hint: Two securities/portfolios that lie on the security market line are the risk-free asset & the market).
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