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In: Finance

Fund A offer an expected return of 8% with a standard deviation of 15%, and Fund...

Fund A offer an expected return of 8% with a standard deviation of 15%, and Fund B offers an

expected return of 5% with a standard deviation of 25%.

a. Would Fund B be held by investors?Explainwith the aid of a diagram using Markowitz Portfoliotheory.(8marks)

b. How would you answer part a. if the correlation coefficient between Funds A and B were 1? Could these expected returnsand standard deviationsrepresent an equilibrium in the market?(12marks)

Solutions

Expert Solution

Answer:

(a) Fund A:
Expected Return = 8%
Standard Deviation (risk)= 15%

Fund B:
Expected Return = 5%
Standard Deviation (risk) = 25%

Since, the Fund A offers higher return at a lower risk as compared to the Fund B which offers lower return and more risk. Therefore, the Fund B should not be held by the investors.

(b) If the correlation of coeeficient between Fund A and Fund B is 1, it reflects that A & B have perfect positive correlation between them.

[Since, the weights are not given, therefore, we have assumed weights to be 0.50 for each fund]

Therefore, the risk of the portfolio = weighted average of the risk = 0.50*15 + 0.50*25 = 20%
And expected return of the portfolio = weighted average of returns = 0.50*8 + 0.50*5 = 6.5%

This portfolio has lower returns and higher risk as compared to the Fund A. Therefore, Fund A is preferrable to the investor.

jeff jeffy answered 1 year ago
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