Doubts

Question (1) exsrcise 3

Question (1) exsrcise 3

by Pietro Loser -
Number of replies: 1

Good afternoon Professor,

I wanted to ask you something regarding the first question of exercise 3. 

I calculated the Excess Market Premium using the CML, and talking to some of my peers, I realized my method was probably wrong and that the correct computation was way simpler.

I still wanted to ask you why using the CML to find the Excess Market Premium by isolating the numerator of the Sharpe Ratio (E(rm) - rf) is considered wrong, especially given the data you provided us with.

What I did: I first calculated the standard deviation of the market which was simply the standard deviation of the portfolio composed by (H,I) since the economy was composed of just the two firms and then I used the formulas present in the photo attached, since the risk free rate and the standard deviation for each firm was already given.

The results (Excess Market Premium = 2.6) was different but close to what I think is the right answer (Correct Excess Market Premium = 2.5)


Thanks in advance,

Pietro Loser 

Attachment cdv_photo_1743180051_20250328164027.jpg
In reply to Pietro Loser

Re: Question (1) exsrcise 3

by Julio Crego -
Dear Pietro,

Thanks a lot for sharing your solution. I think it is very useful for everyone to see why different approaches are not correct.

In this case, your premise is incorrect. These firms are not on the CML. Actually, firms are never (almost) on the CML (see this post for a more in-depth explanation)

One way to double-check it is to compute the Sharpe ratio. The Sharpe ratio of H is 4.75, and the Sharpe ratio of I is 4.67. If they were on the CML, the Sharpe ratio should be equal (and equal to the market). This is the reason why depending on which formula of your image you pick, you get different results. 

Best