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Solution_Practice_Midterm2

# Solution_Practice_Midterm2 - Question 1 The Risk Premium is...

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Question 1 The Risk Premium is defined as the difference between the Stock Market Return and The T-Bill Return So, we get these results Year Risk Premium 1999 18.9% 2000 -16.8% 2001 -14.8% 2002 -22.6% 2003 30.6% The Average Risk Premium is the arithmetic average of these numbers. It is -0.94% To calculate the Standard Deviation of the Risk Premium, we first need to determine the square deviations from the average risk premium, every year Year Deviation from Mean Squared Deviation 1999 19.84% 393.6256 2000 -15.86% 251.5396 2001 -13.86% 192.0996 2002 -21.66% 469.1556 2003 31.54% 994.7716 Sum 2301.192 Then, we pick the sum of the squared deviations and divide by FOUR (not five, because we are using historical data, we need to divide by the number of observation minus one) to get the variance. The square root of the variance is the standard deviation. The number is 23.99%

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Question 2 In this question all you are required to do is to make portfolios combining the portfolio Mr. Edwards already has with the Indexes you can choose from. You will make portfolios where 50% is the old portfolio and 50% will be the index. Notice that, the portfolio is worth \$2 million and the money he has to invest in the indexes is \$2 million also. In the question, the requirement is that the new portfolio has a higher expected return and a lower standard deviation of returns. The results are the following Using Index Expected Return Standard Deviation A 14.4% 21.18% B 12.4% 20.17% C 14.9% 23.44% D 13.9% 21.39% Using Index B is not good, because expected return is reduced. Using Index C is not good because Standard Deviation is increased. You can suggest using either Indexes A or D.
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