Question 3 (15 marks) Consider the following classic portfolio choice problem. Two assets are available to...

 

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Question 3 (15 marks) Consider the following classic portfolio choice problem. Two assets are available to an investor at time t. One is riskless, with simple return R, from time t to t+1, and the other is risky. The risky asset has simple return R from time t to t+1. The investor puts a share w of his portfolio into the risky asset. We assume that the investor trades off mean and variance in a linear fashion. That is, investor maximizes a linear combination of mean and variance, with a positive weight on mean and a negative weight on variance: k u-(E[R,1-50%) a) (7 marks) What is the proportion of wealth invested in risky asset? b) (8 marks) Explain two-fund separation in relation to your answer in part (a). What does k represent and why? Question 3 (15 marks) Consider the following classic portfolio choice problem. Two assets are available to an investor at time t. One is riskless, with simple return R, from time t to t+1, and the other is risky. The risky asset has simple return R from time t to t+1. The investor puts a share w of his portfolio into the risky asset. We assume that the investor trades off mean and variance in a linear fashion. That is, investor maximizes a linear combination of mean and variance, with a positive weight on mean and a negative weight on variance: k u-(E[R,1-50%) a) (7 marks) What is the proportion of wealth invested in risky asset? b) (8 marks) Explain two-fund separation in relation to your answer in part (a). What does k represent and why?

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