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Sample Exam 1 Questions_Solutions

Sample Exam 1 Questions_Solutions - Sample Exam 1 Questions...

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Sample Exam 1 Questions 1) Assume that there are two risky assets, A and B, that are not perfectly correlated, and that asset A has a higher mean and a higher variance than asset B. There is no riskless asset. Draw a curve that shows the means and standard deviations of portfolios that combine the two assets. On this graph, include and label the following: a) Points (labeled “A” and “B”) that show the means and standard deviations of assets A and B. b) The parts of the curve (labeled “short A” and “short B”) that can only be attained by shorting each asset. c) The point “L” representing the portfolio that has the lowest mean return that any risk- averse investor would ever choose. d) The point “50/50” that is achieved by putting 50% of your portfolio in each asset.
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2) Continue to assume that the two risky assets, A and B, are not perfectly correlated. Now, however, asset A has a higher mean and a lower variance than asset B. Furthermore, assume that a riskless asset now exists, and that it’s return is less than the expected return of B (and hence less than the expected return of A). Now draw two curves that show the means and standard deviations of portfolios that combine the two assets. (You can put both curves on the same graph or use two graphs.) Draw the first curve so that the tangent portfolio contains a long position in each asset. Draw the second curve so that the tangent portfolio contains a long position in asset A and a short position in asset B. Label the locations of assets A and B and of the tangent portfolios implied by each curve.
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a) Explain, in the context of the first curve, why no investor would optimally choose to put all his wealth into risky asset A. For the same standard deviation, the investor would rather invest in portfolio X, which combines an investment in the tangent portfolio with a short position in the riskless asset. The portfolio X offers the same standard deviation but a higher mean b) Which curve is consistent with a higher correlation between the two assets? In the first curve, asset B has a net positive demand, while in the second curve asset B has a negative demand. Since B has a lower mean and a higher variance, investors would only hold it if it offered major diversification benefits, or had a low correlation with asset A.
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