Raima Choudhry, Voula Zaphiros, Kevin Pereda, Ariadni Aguilar

Professor Radin
FINC 561-01
29 March 2021

Case Study Intuition Questions:

1. Your client asks why you would combine Portfolio (A), which has a lower Sharpe ratio,
with Portfolio (B) to arrive at the optimal risky portfolio. Prepare a clear and concise
response to your client.

The reasoning behind combining Portofolio A and B is to arrive at an optimal risky

portfolio. An optimal risky portfolio’s main focus is to figure out the optimal combination of two
different portfolios that produce the greatest sharpe ratio. A portfolio that has the highest Sharpe
ratio reflects the greatest reward per unit of risk. The mechanism that allows this phenomenon to
occur is the Modern Portfolio Theory. This mechanism allows the investor to create a more
efficient portfolio through diversification of different assets that have a low correlation. Having
lower correlation between assets results in offsetting risk and improving the quality of
diversification. Diversified portfolio in which both stocks and bonds are held leads to an optimal
combination of asset classes in which the highest Sharpe Ratio will be produced.

2. Your client believes in the weak form of market efficiency as it relates to security
selection. Is Portfolio A’s performance enough justification to prove or disprove this belief?
Why or why not?

Portfolio A’s performance is not enough justification to prove or disprove this belief
because it cannot be used to foresee its future direction for stock prices in the weak form of
market efficiency. Meanwhile, supporters of the weak form efficiency believe that stock prices
reflect all information obtained from historical trading data. Weak form efficiency states that
fundamental analysis, at times, can be flawed and it does not consider a technical analysis to be
accurate. As a result, especially short term, it is exceedingly difficult to outperform the market
and it assumes price momentum does not exist. For instance, if my client sees eye to eye with the
weak form efficiency, then he or she believes it is meaningless in having an active portfolio
manager. Therefore,  given that Portfolio A was constructed, its reason doesn’t support weak
form efficiency. 

3. After further discussions with your client, it turns out that she believes in the semi-form
of market efficiency as it relates ONLY to security selection, what portfolio substitution(s)
would you make to your optimal risky portfolio? No calculations are necessary.

Semi-strong form of market efficiency assumes current prices of the securities reflect
public information and no securities are mispriced. Only way to beat the market is by obtaining
insider information or just having luck. Therefore, the substitution that we would make to the
optimal risky portfolio is modifying security allocation based on the clients utility.  If the client
is seeking to maximize their preference then their utility would increase with portfolio return and
decrease with portfolio risk.  
4. After meeting with the client, she informs you that she prefers a return higher than that
of the optimal risky portfolio.
a. Is this possible to achieve and if so, how? Optimal risky portfolio signifies that at a
specific level of return, the risk of the portfolio is reduced. Since the client prefers a
return higher than that of the optimal risky portfolio this can be done by including more
of the stocks or assets that have a higher risk but also offer higher returns. This will
increase the return of the portfolio as well as the risk. 
b. What does that indicate about your initial assumptions regarding the indifference
curve?
This indicates our initial assumption regarding the indifference curve that each client will
prefer a return that has a low risk at the level of return. Clients have different levels of
risk aversion which will ultimately impact the shape and the movement of the
indifference curve.

5. Portfolio A returned 9.20% p.a. over the evaluation period compared to a 5.00%  p.a. for
the S&P 500. This equates to a difference or outperformance of 4.20% p.a. According to
CAPM, the annualized alpha of portfolio A is 4.74%  p.a.  Explain the difference between
the two numbers. (Note: It is not due to rounding)

The two performance numbers mentioned above do not correlate with each other since
they are calculated differently. The difference in performance between Portfolio A and the S&P
500 is calculated by subtracting each portfolio's returns. Meanwhile, Alpha for Portfolio A was
calculated by using the CAPM equation. The CAPM equation determines the fair value of return
of a portfolio in comparison to its systematic risk vs the market which is the Beta. Alpha is the
abnormal excess return of a portfolio after adjusting for systematic risk. Beta is the measure of
the stocks relative volatility vs that of the market. In conclusion, the difference between the two
numbers is due to the inclusion of the Beta function in one of the calculations in comparison to
the other.