Question
Your current portfolio is 100% invested in the market. You are considering investing some of your money in a portfolio run by Big Alpha Asset
Your current portfolio is 100% invested in the market. You are considering investing some of your money in a portfolio run by Big Alpha Asset Management (BAAM).
BAAM's returns have been quite good over the last five years. In order to understand by how much you could improve the Sharpe Ratio of your current portfolio by putting some of your money in BAAM, you run the following regression using past annualized returns on both the market and BAAM:
Rbaam,t - Rft = ai + Bi (Rm,t - Rft) + ei,t
You estimate the following coefficients, which are all statistically significant:
alpha = 0.06, Beta = 1.2
Additionally. you estimate the volatility of the residuals from the above regression (idiosyncratic volatility) to be 0.12.
In that same period the market's annualized volatility was 0.2078. Additionally, you expect the market's excess return to be 0.05 over the coming year.
If you believe that the above estimates are representative of what will happen in the coming year, what is the maximum Sharpe Ratio you would be able to achieve by combining your current market portfolio with BAAM?
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