Two Part Question
First Question
You are currently only invested in the Silverman Fund (aside from risk-free securities). It has an expected return of 14% with a volatility of 20%. Currently, the risk-free rate of interest is 3.8%. Your broker suggests that you add Easton Corporation to your portfolio. Easton Corporation has an expected return of 20%, a volatility of 60%, and a correlation of 0 with the Silverman Fund.
a. Is your broker right?
b. You follow your broker's advice and make a substantial investment in Easton stock so that, considering only your risky investments, 60% is in the Silverman Fund and 40% is in Easton stock. When you tell your finance professor about your investment, he says that you made a mistake and should reduce your investment in Easton. Is your finance professor right?
c. You decide to follow your finance professor's advice and reduce your exposure to Easton. Now Easton represents 15% of your risky portfolio, with the rest in the Silverman fund. Is this the correct amount of Easton stock to hold?
Second Question
Calculate the Sharpe ratio of each of the three portfolios in Problem 40 (the initial portfolio with 0% invested in Easton, the second portfolio with 40% invested in Easton, and the third portfolio with 15% invested in Easton). What portfolio weight in Easton stock maximizes the Sharpe ratio?