Question: Q4. Suppose that a portfolio consists of two assets A and B whose returns are given by RA = RM UA and RB = 2RM UB, where RM is the market return, which is uncertain, and where u and up are uncorrelated shocks with expected value of zero and variance of 0.01. (a) Suppose RM has expected value of 0.05 and a variance of 0.01. Calculate the expected returnShow transcribed image textTranscribed image text: Q4. Suppose that a portfolio consists of two assets A and B whose returns are given by RA = RM UA and RB = 2RM UB, where RM is the market return, which is uncertain, and where u and up are uncorrelated shocks with expected value of zero and variance of 0.01. (a) Suppose RM has expected value of 0.05 and a variance of 0.01. Calculate the expected return and variance of both assets A and B. [2 marks] (b) Suppose an investor is wanting to purchase a portfolio of the two stocks. If investors will only buy the portfolio if its variance does not exceed 0.03, what is the maximum proportion of asset B in the portfolio? What is the expected return on the portfolio at this maximum proportion? (Hint: Write down an expression for the return on a portfolio containing a proportion 1-a of asset A and a proportion a of asset B.) [5 marks] (c) Briefly compare what happens to expected returns and variance when we switch from B to A versus when we switch form B to the portfolio. Is the second switch a better “deal” when reducing one’s risk, and if so, why? [3 marks]
