CAT 2007 Question 8

Instructions

Directions for the following two questions: Shabnam is considering three alternatives to invest her surplus cash for a week. She wishes to guarantee maximum returns on her investment. She has three options, each of which can be utilized fully or partially in conjunction with others.

Option A: Invest in a public sector bank. It promises a return of +0.10%.

Option B: Invest in mutual funds of ABC Ltd. A rise in the stock market will result in a return of +5%, while a fall will entail a return of – 3%.

Option C: Invest in mutual funds of CBA Ltd. A rise in the stock market will result in a return of – 2.5%, while a fall will entail a return of + 2%.

Question 8

What strategy will maximize the guaranteed return to Shabnam?

Solution

Let a, b and c be the percentages of amount invested in options A, B and C respectively => a + b + c = 100

Return attained if there is a rise in the stock market => 0.001a + 0.05b - 0.025c

Return attained if there is a fall in the stock market => 0.001a - 0.03b + 0.02c

Maximum guaranteed return is attained when both are equal because it is indifferent to rise and fall in the market.

0.001a + 0.05b - 0.025c = 0.001a - 0.03b + 0.02c

=> 0.08b = 0.045c => 16b = 9c

Let's put the values for a, b and c that satisfy the above equation.

b = 9, c = 16, a = 75 => return = 0.125

b = 18, c = 32, a = 50 => return = 0.15

b = 27, c = 48, a = 25 => return = 0.175

b = 36, c = 64, a = 0 => return = 0.2

Hence, the maximum guaranteed return is 0.2% and it is attained when 36% is invested in option B and 64% is invested in option C.


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