Session 7:

A.

Locating the ORP & OBP

The expected return and risk of a portfolio of risky assets, E(RP) and P, are expressed as:

n n n 2 2 E (RP ) = wi E (ri ) , P = wi i + wi w j ij i =1 j =1 i =1 i =1 i j where wi and wj are the weights allocated to the respective risky assets, the total weight is one, E(ri) the expected return on risky asset i, n the total number of risky assets in the portfolio, i the standard deviation of returns of risky asset i, and ij the covariance of returns between risky assets i and j.
n

1 2

For a balanced portfolio, the expected return and risk, E(RB) expressed as:

and B, are

E (R B ) = y P E (R P ) + (1 y P )r f ,
where

2 2 2 B = yP P + (1 y P ) r2 + 2 y P (1 y P ) P , r = y P P
f f

yP is the weight allocated to the portfolio of risky assets,

B.
When risk free lending and borrowing are not available, investors choose the portfolio of risky assets offering the highest utility. Among all the portfolio of risky assets lying on the efficient frontier, investors choose the one that touches their indifference curves tangentially.
IC IC IC ORPMRA P

Expected return

ORPLRA

efficient frontier

Optimal risky portfolio for a less risk averse investor with a smaller A and gently sloped indifference curve

Optimal risky portfolio for a more risk averse investor with a larger A and steeper indifference curves Standard deviation of returns

Expected return CALORP CALORP(LRA) CALORP(MRA) B1 rf B2 efficient frontier ORPLRA - Optimal risky portfolio for the less risk averse investor in the absence of a risk-free asset ORP Optimal risky portfolio for any investor in the presence of a risky free asset ORPMRA - Optimal risky portfolio for the more risk averse investor in the absence of a risk-free asset Standard deviation of returns

When risk free lending and borrowing are available, investors choose the portfolio of risky assets offering the highest reward to variability ratio. ORP is chosen by both the more or less risk averse. Their previously chosen portfolios of risky assets with the highest utility, i.e., ORPMRA and ORPLRA, are no longer efficient as they can now combine ORP and the risk free asset to form another portfolio that offers a higher level of expected return at the same level of risk.

H. i) RTVR - reward to variability ratio For EP1, RTVR = (10% - 4%) / 4% = 1.5 For EP2, RTVR = (16% - 4%) / 20% = 0.6 EP1 is preferred as it has the larger reward to variability ratio. ii) The RTVR of the other portfolio must equate to 1.5. Let the expected return of the other portfolio be ?, (? 4%) / 20% = 1.5 ? = 34% iii)The investor should form a balanced portfolio consisting of EP1 and rf with the following composition where y is the proportion of funds in EP1: y 0.1 + (1 - y) 0.04 = 0.34 y = 5 OR y 0.04 = 0.20 y=5 With an initial wealth of $100, the investor should borrow $400 (since 1 - y = 4) at the risk free rate and invest $500 in EP1.