Lecture 1

Question 1

How are excess returns on an asset defined?

Answer 1

The difference between the expected return on asset A and the risk free rate.

It can also be defined as the return on a portfolio borrowing 1 monetary unit at the interest of the risk free rate and purshasing 1 monetary unit of asset A.)

Question 2

In which two components can we divide the return on an asset? Give a conceptual explanation of the two.

Answer 2

The sum of the risk free return (known) and excess returns on the asset (random variable).

The former is compensation for defered consumption, while the later is compensation for risk.

Question 3

What is the Capital Allocation Line and how does one derive it.

Answer 3

the CAL illustrates the relationship between Expected returns on a portfolio, the risk-free asset and the variance of the asset.

1. Calculate expected returns on a portfolio of asset A and the Risk Free asset.
2. Calculate the variance of the portfolio.
3. Replace w.

Question 4

When superimposing the Sharpe ratio and the investor’s utility, what is the relationship between the SR and investor utility.

Answer 4

The SR is tangent to the utility function. The higher the SR, the greater the utility.