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Question: You advise a local pension fund that is considering investments in a combination of a risky stock portfolio return today with E[rP] = 10% and σP = 18% and today's risk-free asset Rf = 3.0%. These returns decrease with the bear markets due to inflation containment actions by FED Reserve to a Rf interest rate of 5.0% and the market Rp falls back to the longer-term low expectation portfolio premium of 5.0%. Remember to analyze the changed returns/expectations based on FED actions and possible recession - today and in the future After careful discussions / surveys with your clients you determine that their risk aversion is A=6. CHOSE ONE PROBLEM
1. Portfolio risk and return: Your clients have a traditional balanced portfolio -- currently invest y=0.6 in the risky portfolio and 1-y=0.4 in the risk-free asset / fixed income. What is the expected return and standard deviation of their portfolio (the complete portfolio)? Today and in future with the higher Rf interests rates?
Note changes in Rf and risk premium and estimated portfolio returns? How does the Sharpe ratio of your combined portfolio (the y choice) change with the new combined return due to Rf increase and Rp decrease with the same long-run SD. Compare Sharpe ratios based on expected combine returns with future Rf and Rp. What does it tell you about these investment allocations? Do these calculations and estimates make sense, what are your concerns?
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