bkmsol_ch06

# C in part b the market risk premium is expected to be

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c. In part (b), the market risk premium is expected to be higher than in part (a) and market risk is lower. Therefore, the reward-to-variability ratio is expected to be higher in part (b), which explains the greater proportion invested in equity. 24. Assuming no change in risk tolerance, that is, an unchanged risk aversion coefficient (A), then higher perceived volatility increases the denominator of the equation for the optimal investment in the risky portfolio (Equation 6.12). The proportion invested in the risky portfolio will therefore decrease. 6-8

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25. a. E(r C ) = 8% = 5% + y(11% – 5%) 5 . 0 5 11 5 8 y = = b. σ C = y σ P = 0.50 × 15% = 7.5% c. The first client is more risk averse, allowing a smaller standard deviation. 26. Data: r f = 5%, E(r M ) = 13%, σ M = 25%, and = 9% B f r The CML and indifference curves are as follows: P borrow lend CAL E(r) σ 5 9 13 25 CML 27. For y to be less than 1.0 (so that the investor is a lender), risk aversion (A) must be large enough such that: 1 A σ r ) E(r y 2 M f M < = 1.28 0.25 0.05 0.13 A 2 = > For y to be greater than 1.0 (so that the investor is a borrower), risk aversion must be small enough such that: 1 A σ r ) E(r y 2 M f M > = 0.64 0.25 0.09 0.13 A 2 = < For values of risk aversion within this range, the client will neither borrow nor lend, but instead will hold a complete portfolio comprised only of the optimal risky portfolio: y = 1 for 0.64 ≤ Α ≤ 1.28 6-9
28. a. The graph for Problem 26 has to be redrawn here, with: E(r P ) = 11% and σ P = 15% b. For a lending position: 2.67 0.15 0.05 0.11 A 2 = > For a borrowing position: 0.89 0.15 0.09 0.11 A 2 = < Therefore, y = 1 for 0.89 A 2.67 M CML E(r) σ 5 9 13 25 11 15 CAL F 29. The maximum feasible fee, denoted f, depends on the reward-to-variability ratio. For y < 1, the lending rate, 5%, is viewed as the relevant risk-free rate, and we solve for f as follows: 25 5 13 15 f 5 11 = % 2 . 1 25 8 15 6 f = × = For y > 1, the borrowing rate, 9%, is the relevant risk-free rate. Then we notice that, even without a fee, the active fund is inferior to the passive fund because: 16 . 0 25 9 13 13 . 0 15 9 11 = < = 6-10

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