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 Funds (S) 24% 30%

Bonds Funds (B) 12 19

The correlation between the fund returns is 0.13. Solve numerically for the proportions of each asset and for the expected return and standard deviation of the optimal risky portfolio.

Portfolio invested in stocks?

Portfolio invested in bonds?

Expected return?

Standard Deviation?

(Do not round intermediate calculations. Enter your answers as decimals rounded to 4 places.)

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
w(*d)= ((E[Rd]-Rf)*Var(Re)-(E[Re]-Rf)*Cov(Re,Rd))/((E[Rd]-Rf)*Var(Re)+(E[Re]-Rf)*Var(Rd)-(E[Rd]+E[Re]-2*Rf)*Cov(Re,Rd)
							Where
						Stock fund	E[R(d)]=	24.00%
bond fund	E[R(e)]=	12.00%
Stock fund	Stdev[R(d)]=	30.00%
bond fund	Stdev[R(e)]=	19.00%
	Var[R(d)]=	0.09000
	Var[R(e)]=	0.03610
T bill	Rf=	8.00%
Correl	Corr(Re,Rd)=	0.13
Covar	Cov(Re,Rd)=	0.0074
Stock fund	Therefore W(*d) (answer a)=	0.6941
bond fund	W(*e)=(1-W(*d)) (answer b)=	0.3059
	Expected return of risky portfolio (answer c)=	20.33%
	Risky portfolio std dev (answer Risky portfolio std dev)=	22.34%
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