Problem 2.

a) (5 pts) We have a financial market consisting of two risky assets. Assume that 1 = 0.1, 2 = 0.05, 1 = 0.2 and 2 = 0.15. If you know that the expected return of the minimum variance portfolio is larger than 7%, find the possible values of the correlation 12.

b) (5 pts) We have a financial market with one risk-free and two risky assets. Assume that 1 = 0.1, 1 = 0.2, 2 = 0.15, Cov(K1, K2) = 12 and R = 5%. Find 2 such that there is no arbitrage on the market. (Hint: Construct a portfolio of the two risky assets with variance 0)

c) (5 pts) We have a financial market with one risk-free and two risky assets. Assume that 1 = 0.1, 2 = 0.12, 1 = 0.05, 2 = 0.10 and R = 5%. You are allowed to invest in the risk-free asset and only one of the risky assets. Which of the risky assets would you choose? What if the risk-free return was R = 10%?