A portfolio management house approximates the return-generating process by a twofactor model and uses two factor portfolios to construct its passive portfolio. The input table that is constructed by the house analysts looks as follows:
The correlation coefficient between the two factor portfolios is .6.
a. What is the optimal passive portfolio?
b. By how much is the optimal passive portfolio superior to the single-factor passive portfolio, M, in terms of Sharpe’s measure?
c. Analyze the utility improvement to the A = 2.8 investor relative to holding portfolio M as the sole risky asset that arises from the expanded macro model of the portfolio manager.