A big pharmaceutical company, DRIg, has just announced a potential cure for canc

Question

A big pharmaceutical company, DRIg, has just announced a potential cure for cancer. The stock price went from $5 to $100 in one day. A friend of yours calls you on the phone to tell you that he owns DRIg. You proudly reply that so do you. Since you have been friends for some time, you know that he holds the market, as do you, and so you both are invested in this stock. Both of you care only about expected return and volatility. The risk-free rate is 3%, quoted as an APR based on a 365-day year. DRIg made up 0.20% of the market portfolio before the news announcement.

a. On the announcement your overall wealth went up by 1.0%

(assume all other price changes cancelled out so that without DRIg, the market return would have been zero). How is your wealth invested?

b. Your friend's wealth went up by 2.0%.

How is his wealth invested?

Explanation / Answer

Solution:

a. 26.16% is in the market; the rest in the risk-free asset.

b. 52.53% is in the market; the rest in the risk-free asset.

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