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The risk-free rate is 4%. The optimal tangency (market) portfolio has an expected return of 18% and a standard deviation of 25%. You currently own a portfolio with an expected return of 10% and a standard deviation of 20%.
A. What is the Sharpe ratio (i.e. risk-return trade-off) of the market portfolio?
B. What is the Sharpe ratio of your current portfolio?
C. Based on your answers from parts A. and B., explain why your current portfolio is inefficient (note: a picture may suffice).
D. What is the expected return that you can earn on an efficient portfolio with the same standard deviation as your current portfolio? What is the composition (assets and weights) of this new portfolio? What is the Sharpe ratio of this new portfolio?
E. What is the standard deviation that you face on an efficient portfolio with the same expected return as your current portfolio? What is the composition (assets and weights) of this new portfolio? What is the Sharpe ratio of this new portfolio?
F. Based on your answers from parts A., D. and E., what do you notice about the risk-return trade-offs of the market and of the two new efficient portfolios?
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