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PRMIA Exam 8006 Topic 4 Question 3 Discussion

Actual exam question for PRMIA's Exam I: Finance Theory, Financial Instruments, Financial Markets ? 2015 Edition exam
Question #: 3
Topic #: 4
[All Exam I: Finance Theory, Financial Instruments, Financial Markets ? 2015 Edition Questions]

The rule that optimal portfolios will maximize the Sharpe ratio only applies when which of the following conditions is satisfied:

1. It is possible to borrow or lend any amounts at the risk free rate.

II. Investors' risk preferences are fully described by expected returns and standard deviation.

III. Investors are risk neutral

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Suggested Answer: D

The Sharpe ratio does not require investors to be risk neutral, only that for a given level of returns they prefer less risk to more risk. (Risk neutral means that investors are indifferent to the level of risk, and are only driven by a desire to maximizing expected value, regardless of risk levels.)

The ability to borrow and lend any amounts of money at the risk free rate is a fundamental assumption for the rule that optimal portfolios will maximize the Sharpe ratio.

This rule also assumes that risk preferences are completely described by return and standard deviation of returns.

Therefore Choice 'd' is the correct answer as statements I and II are correct.


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