Question

A pension fund manager is considering three mutual funds. The first is a stock fund, the second is a long-term government and corporate bond fund, and the third is a T-bill money market fund that yields a rate of 8%. The probability distribution of the risky funds is as follows:

	Expected Return			Standard Deviation
Stock fund (S)		22	%		37	%
Bond fund (B)		14			23

The correlation between the fund returns is 0.10.

  

Solve numerically for the proportions of each asset and for the expected return and standard deviation of the optimal risky portfolio. (Do not round intermediate calculations. Enter your answers as decimals rounded to 4 places.)

	Portfolio invested in the stock Portfolio invested in the bond Expected return Standard deviation

Answer 1

To find the fraction of wealth to invest in Stock fund that will result in the risky portfolio with maximum Sharpe ratio the following formula to determine the weight of Stock fund in risky portfolio should be used

	Where
Stock fund	E[R(d)]=	22.00%
Bond fund	E[R(e)]=	14.00%
Stock fund	Stdev[R(d)]=	37.00%
Bond fund	Stdev[R(e)]=	23.00%
	Var[R(d)]=	0.13690
	Var[R(e)]=	0.05290
T bill	Rf=	8.00%
Correl	Corr(Re,Rd)=	0.1
Covar	Cov(Re,Rd)=	0.0085
Stock fund	Therefore W(*d)=	0.4954
Bond fund	W(*e)=(1-W(*d))=	0.5046
	Expected return of risky portfolio=	0.1796
	Risky portfolio std dev=	0.2265

Where
Var = std dev^2
Covariance = Correlation* Std dev (r)*Std dev (d)
Expected return of the risky portfolio = E[R(d)]*W(*d)+E[R(e)]*W(*e)
Risky portfolio standard deviation =( w2A*σ2(RA)+w2B*σ2(RB)+2*(wA)*(wB)*Cor(RA,RB)*σ(RA)*σ(RB))^0.5