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 sure rate of 4.8%. The probability distributions of the risky funds are:

	Expected Return	Standard Deviation
Stock fund (S)	18%	38%
Bond fund (B)	9%	32%

The correlation between the fund returns is 0.1313.

What is the Sharpe ratio of the best feasible CAL? (Do not round intermediate calculations. Round your answer to 4 decimal places.)

Answer 1

Sharpe ratio provides the excess of average return over the risk-free rate per unit of total risk. The sharpe ratio of the best feasible CAL (Capital Allocation Line) can be found by following steps:

Step 1: Find the risk premium of expected return over risk free rate

Step 2: Find the covariance of the funds

Step 3: Find the investment propotion of the funds

Step 4: Find the expected return of the portfolio basis the investment proportion

Step 5: Find the standard deviation of the portfolio

Step 6: Sharpa ratio = (Expected return of portfolio - risk free rate) / standard deviation of the portfolio

Sharpe ratio of the best feasible CAL = 0.3579

Workings: