Using sample average returns and standard deviations of the volatility strategy discussed in class, calculate the optimal proportion that a mean-variance utility investor would invest in the volatility strategy in the following scenarios: a) Risk-free rate is 0.50% and ? = 3. b) Risk-free rate is 0.50% and ? = 5. c) Risk-free rate is 0.75% and ? = 3. d) What can be said about the effect of the risk-free rate and the risk-aversion coefficient on the optimal allocation to the volatility strategy?
Sloution
What is a Mean-Variance Analysis?
Sample Mean-Variance Analysis
Sample Mean-Variance Analysis
It is possible to calculate which investments have the greatest variance and expected return. Assume the following investments are in an investor's portfolio:
Investment A: Amount = $100,000 and expected return of 5%
Investment B: Amount = $300,000 and expected return of 10%
In a total portfolio value of $400,000, the weight of each asset is:
Investment A weight = $100,000 / $400,000 = 25%
Investment B weight = $300,000 / $400,000 = 75%
Therefore, the total expected return of the portfolio is the weight of the asset in the portfolio multiplied by the expected return:
Portfolio expected return = (25% x 5%) + (75% x 10%) = 8.75%Portfolio variance is more complicated to calculate, because it is not a simple weighted average of the investments' variances. The correlation between the two investments is 0.65. The standard deviation, or square root of variance, for Investment A is 7 percent, and the standard deviation for Investment B is 14 percent.
In this example, the portfolio variance is:
Portfolio variance = (25% ^ 2 x 7% ^ 2) + (75% ^ 2 x 14% ^ 2) + (2 x 25% x 75% x 7% x 14% x 0.65) = 0.0137
The portfolio standard deviation is the square root of the answer: 11.71% i.e. 12%
Coefficient of Risk version
we use the following utility formula U = E(r) – 0,5 x A x σ2
U=Represents the utility or score to give this investment in a given portfolio by comparing it to a risk-free investment.
E(r)= expected Return
σ2=the square of volatility
a) U = E(r) – 0.5 x A x σ2
= 0.08 - 0.5 X 3 X 0.122 = 5.84%
b) U = E(r) – 0.5 x A x σ2
0.08 - 0.5 X 5 X 0.122 = 4.40%
b) U = E(r) – 0.5 x A x σ2
0.08 - 0.5 X 3 X 0.122 = 5.84%
No we can not say that Risk free Rate and risk aversion coefficient on the optimal allocation to the volatility strategy.
Using sample average returns and standard deviations of the volatility strategy discussed in class, calculate the...
Stocks A & B have the expected returns and standard deviations shown in the table below: Stock E(R) 12% 30% 19% 50% The correlation between A and B is 0.4. The risk-free rate is 3% and you have a risk-aversion parameter of 2. What is the proportion of your investment in A and B, respectively, in your optimal risky portfolio?
We have discussed in class the idea that one may measure an investor's risk tolerances to different investment scenarios and then develop a mathematical model to describe the satisfaction or utility that an investor derives from his or her investments. This mathematical function is typically called a "utility" function and greater values of utility mean greater investor satisfaction. Consider the following investor utility function U = E(r) - (A/2)o where U is the inventor's utility, E() is a portfolio's expected...
2. Consider an economy with 2 risky assets and one risk free asset. Two investors, A and B, have mean-variance utility functions (with different risk aversion coef- ficients). Let P denote investor A's optimal portfolio of risky and risk-free assets and let Q denote investor B's optimal portfolio of risky and risk-free assets. P and Q have expected returns and standard deviations given by P Q E[R] St. Dev. 0.2 0.45 0.1 0.25 (a) What is the risk-free interest rate...
The annualised market risk premium is 5% and has annualised volatility of 22.36%. A friend of yours, who is a mean-variance utility maximiser, invests 50% of their portfolio in the market portfolio and 50% of their portfolio in the risk-free asset is 3% p.a.. You can infer that your friend’s risk aversion coefficient, A, is closest to:
am i Saved Two assets have the following expected returns and standard deviations when the risk-free rate is 5%: Asset A E(rA) 10% o20% Asset B E(rB) = 15% OB - 27% An investor with a risk aversion of A 3 would find that on a risk-return basis. Multiple Choice only asset A is acceptable only asset B is acceptable
You are presented with information on expected returns and standard deviations for 2 assets and a portfolio that was formed with equal proportions of each asset. Asset J Asset K 00800 0.1200 0.0914 Asset L Portfolio Expected return 0.03 0.0767 Variance 0.0842 0.0566 Which of the following statements is true (there are several, select all that are correct): If you want to decrease the risk (standard deviation) of the portfolio, you will increase the proportion to invest in asset J...
a. Given the following holding-period returns, compute the
average returns and the standard deviations for the Zemin
Corporation and for the market.
b. If Zemin's beta is 1.98 and the risk-free rate is 7
percent, what would be an expected return for an investor owning
Zemin? (Note: Because the preceding returns are based on monthly
data, you will need to annualize the returns to make them
comparable with the risk-free rate. For simplicity, you can
convert from monthly to...
An investor has mean-variance utility preferences: U = E(R) – 0.5A02 coefficient of risk aversion A = 5. market expected return is E(RM) = 5% standard deviation of the market is om = 10%. risk-free rate is Rf = 2%. Under CAPM, what's the weight of the risk-free assets (Wf) on your optimal portfolio?
Assume an investor has mean-variance utility preferences U = E(R) - 0.5A02 with coefficient of risk aversion A = 5. The market expected return is E(RM) = 5% and the standard deviation of the market is OM = 10%. The risk-free rate is Rs = 2%. Under CAPM, what's the weight of the risk-free assets (We) on your optimal portfolio?
1.3 (5 points) Two stocks have the following expected returns and standard deviations Stock Stock Expected return Standard Deviation A 10% 12% B 15% 20% Consider a portfolio of A and B, and let w, and wg denote the portfolio weights of these two assets, with W + W, =1. Suppose that the correlation between the expected returns on A and B is equal to 0.3. Use these data to construct the portfolio of A and B with the lowest...