You convince your client to think more about how to mix different assets. You first focus on splitting the investment between a broad-based index of the US stock market (M) and T-bills. Your analysis tells you that E(rm)=9%, σm=18 %. T-bills offer a 2% risk-free rate of return.
STEP BY STEP SHOW
A) You first take a close look at the investment choices. What is the Sharpe ratio of the market?
B) If your investor wanted to achieve an expected return of 8% by mixing by T-bills and the market portfolio M, what fraction y of funds would she invest in the risky asset?
C) If your client has risk aversion A=3, what is her optimal investment weight y in the risky asset? What does your client have to do in order to achieve this optional mix of the two assets?
D) Due to recent market turmoil following the failure of the US bailout, you update your estimate of future volatility over the next year to σm=24%. What is the new optimal investment weight y?