Required: a-1. Assuming the correlation between the annual returns on the two portfolios is indeed zero, what would be the optimal asset allocation? a-2. What is the expected risk premium on the portfolio?
Greta has risk aversion of A = 3 and a 1 - year investment horizon. She is pondering two
portfolios, the S&P 500 and a hedge fund, as well as a number of 1 - year strategies. (All
rates are annual and continuously compounded.) The S&P 500 risk premium is estimated at
9% per year, with a standard deviation of 23 % . The hedge fund risk premium is estimated
at 11% with a standard deviation of 38% . The returns on both of these portfolios in any
particular year are uncorrelated with its own returns in other years. They are also
uncorrelated with the returns of the other portfolio in other years. The hedge fund claims the
correlation coefficient between the annual return on the S&P 500 and the hedge fund return
in the same year is zero, but Greta is not fully convinced by this claim. Required: a-1.
Assuming the correlation between the annual returns on the two portfolios is indeed zero,
what would be the optimal asset allocation? a-2. What is the expected risk premium on the
portfolio? Req A1 S&P: ? ? Hedge: ? ? Req A2: Expected risk premium: ? ?
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