Question

Section B: Short Answer Questions 1. Discuss why common stocks must earn a risk premium. 2. Discuss how the investor can use the separation theorem and utility theory to produce an efficient portfolio suitable for the investor's level of risk tolerance. 3. Two risky assets with returns ri, r, and standard deviations 01, 02, and correlation p. Calculate the weights for the following two optimal portfolios. a. Minimum volatility (variance) portfolio minimizes the overall risk min 0, s.t. W, + = 1 b. Maximum Sharpe Ratio portfolio delivers the highest expected return of unit of risk max pers w Op s.t. W1 + W2 = 1

Answer 1

1]

Common stocks are a risky asset. Their returns in the form of dividends and capital appreciation are uncertain as they depends on various uncertain factors such as performance of company, cash flows available to pay dividends, dividend policy, overall market conditions etc.

On the other hand, risk free assets such as Treasury securities do not have uncertainty of cash flows. Their coupon payments, and redemption value will be paid irrespective of any factors. Hence, they are called risk free assets.

Risk and return are directly related. Higher the risk, higher the required return and lower the risk, lower the required return. This is because investors require a higher return for investing in assets with higher risk, to compensate them for the additional risk they undertake.

Therefore, common stocks must earn a risk premium over the risk free rate because investors must be compensated for the additional risk involved in investing in the risky assets.