Optimal Asset Allocation with Risk Aversion of 3: S&P 500 vs Hedge Fund

Math Problem Statement

Greta has risk aversion of A = 3 when applied to return on wealth over a 1-year 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 5% per year, with a standard deviation of 20%. The hedge fund risk premium is estimated at 12% with a standard deviation of 35%. 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 0.3, what would be the optimal asset allocation?

Solution

To determine Greta's optimal asset allocation, we need to maximize her utility given her risk aversion and the properties of each portfolio.

Step-by-Step Solution:

Define Variables:
- Risk Aversion (A): 3
- Expected Returns (Risk Premiums):
  - S&P 500, $E[R_{SP}]$ : 5%
  - Hedge Fund, $E[R_{HF}]$ : 12%
- Standard Deviations:
  - S&P 500, $\sigma_{SP}$ : 20%
  - Hedge Fund, $\sigma_{HF}$ : 35%
- Correlation between S&P 500 and Hedge Fund: 0.3
Portfolio Expected Return: Let $w_{SP}$ be the weight of the S&P 500 in the portfolio, and $w_{HF} = 1 - w_{SP}$ be the weight of the hedge fund. The expected return of the portfolio $E[R_p]$ can be calculated as: [ E[R_p] = w_{SP} \cdot E[R_{SP}] + w_{HF} \cdot E[R_{HF}] ]
Portfolio Variance: The variance $\sigma_p^2$ of the portfolio return is given by: $\sigma_p^2 = w_{SP}^2 \cdot \sigma_{SP}^2 + w_{HF}^2 \cdot \sigma_{HF}^2 + 2 \cdot w_{SP} \cdot w_{HF} \cdot \sigma_{SP} \cdot \sigma_{HF} \cdot \text{corr}(SP, HF)$
Portfolio Utility: Greta’s utility function for a portfolio with a risk aversion of $A$ is: $U = E[R_p] - \frac{A}{2} \sigma_p^2$ To maximize this utility, we’ll differentiate with respect to $w_{SP}$ and set the derivative equal to zero.
Setting Up and Solving for Optimal Allocation: Substitute the expected returns, standard deviations, and correlation into the utility function, differentiate with respect to $w_{SP}$ , and solve for $w_{SP}$ .

Plugging in the Values:

For:

$E[R_{SP}] = 0.05$ , $E[R_{HF}] = 0.12$
$\sigma_{SP} = 0.20$ , $\sigma_{HF} = 0.35$
Correlation $= 0.3$

This will yield Greta's optimal asset allocation.

Would you like to see the explicit calculations for each step?

Ask a new question for Free

By Image

Drop file here or Click Here to upload

Math Problem Analysis

Mathematical Concepts

Portfolio Theory
Expected Return
Portfolio Variance
Utility Maximization

Formulas

Portfolio Expected Return: E[R_p] = w_SP * E[R_SP] + w_HF * E[R_HF]
Portfolio Variance: σ_p^2 = w_SP^2 * σ_SP^2 + w_HF^2 * σ_HF^2 + 2 * w_SP * w_HF * σ_SP * σ_HF * Corr(SP, HF)
Utility Function: U = E[R_p] - (A/2) * σ_p^2

Theorems

Modern Portfolio Theory
Mean-Variance Optimization

Suitable Grade Level

Undergraduate - Finance/Economics

Related Recommendation

Pension Fund Manager Portfolio Optimization with Stock, Bond, and T-bill Funds

Determining Portfolio Allocation with Risk Aversion

Two-Asset Portfolio: Expected Return and Standard Deviation Calculation

Portfolio Optimization with Three Risky Assets: Minimum-Variance and Optimal Portfolio

Investment Proportion and Expected Return in a Risky Portfolio