Explanation:
First, calculate the Market Risk Premium (MRP): MRP = Market return - Risk-free rate = 8% - 3% = 5%.
Next, calculate Jensen's Alpha for each asset. Alpha = Return - [Risk-free rate + Beta * (Market return - Risk-free rate)].
14% - (3% + 1.20 * 5%) = 14% - 9% = 5%13% - (3% + 0.90 * 5%) = 13% - 7.5% = 5.5%13% - (3% + 1.00 * 5%) = 13% - 8% = 5%10% - (3% + 0.80 * 5%) = 10% - 7% = 3%The portfolio manager requires Jensen's Alpha to be greater than or equal to the market risk premium (which is 5%). Therefore, Asset STU is eliminated since its alpha (3%) is less than 5%.
Among the remaining assets (BDE, JKL, MNO), the manager seeks the lowest marginal VaR. Marginal VaR is proportional to the asset's beta to the portfolio. Since Asset JKL has the lowest beta (0.90) among the qualifying assets, it provides the lowest marginal VaR. Thus, the manager should select Asset JKL.
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| Asset | Portfolio weight | Return | Volatility of return | Beta to the portfolio |
|---|---|---|---|---|
| BDE | 0.35 | 14% | 19% | 1.20 |
| JKL | 0.30 | 13% | 18% | 0.90 |
| MNO | 0.25 | 13% | 16% | 1.00 |
| STU | 0.10 | 10% | 10% | 0.80 |
The portfolio manager wants to select the asset that has the lowest marginal VaR as long as its Jensen’s alpha is greater than or equal to the market risk premium. Assuming the risk-free interest rate is 3% and the market return is 8%, which asset should the portfolio manager select?
A
Asset BDE
B
Asset JKL
C
Asset MNO
D
Asset STU