0 = (53.2)(0.25) +(6)(0.725) +(6)(0.75) +(6)(0.75)

55.0 = (53.2)(0.25)

+(55.6)(0.725)

+(55.6)(0.75)

Part B

Corner Portfolio 5 and the risk-free portfolio should be included in the new strategic asset

allocation, because some combination of the two portfolios will be mean-variance superior to

any other combination of different portfolios that also satisfy the director’s revised return

requirement and risk tolerance.

The Corner 5 portfolio is the tangency portfolio (the highest-Sharpe-ratio efficient portfolio at

0.284). Combinations of the tangency portfolio (expected return = 8.00%) and the risk-free

portfolio (expected return = 4.00%) that place at least a 50% weight on the tangency portfolio

will satisfy the director’s return requirement [(8% × 0.50) + (4% × 0.50) = 6%] and will lie on

the Capital Allocation Line (CAL). Portfolios on the CAL provide the lowest level of risk for a

given level of expected return (or highest expected return for a given level of risk). Among the

portfolios satisfying the director’s return requirement, some—including the 50/50 portfolio mix

of Corner Portfolio 5 and the risk-free portfolio—will also be consistent with the director’s

specified risk tolerance. (For example, the standard deviation of the 50/50 portfolio is 7.05% =

(0.5)(14.1), well below the new constraint of 12%). Lourie would choose from among these

latter portfolios for the new strategic asset allocation.

LEVEL III, QUESTION 4

Topic: Portfolio Performance Measurement

Minutes: 10

Reading Assignments: