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Suppose there are two uncorrelated assets in the market. You may invest in one or any combination of these risky financial assets over the next period. The expected rate of return ¹ is the same for both assets. However, the riskiness of the assets are different (suppose the standard deviations are σ1 < σ2).
a) Show the assets on a mean return-standard deviation graph.
b) Describe the feasible and efficient sets of investments and visually show rough representations on the graph you drew for part a.
c) Can a rational and risk averse investor such as yourself form a portfolio through diversification that is better than each individual asset? Explain.
d) What are the optimal portfolio weights and the minimum variance for an investor like you? Derive and express them in terms of the parameters you are given.
e) Show the portfolio on the graph you used for parts a and b.
What is one of the most important lessons from capital market history?
Explain the difference between buying a forward contract for delivery at $100 in one year, buying a call option struck at $100 expiring in one year, and selling a put option struck at $100 expiring in one year.
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