Question

There are two mutual funds, the first is an equity fund and the second is a long-term corporate bond fund. It is possible to borrow or to lend limitless sums safely at 1.25%pa. The data on the risky funds are as follows:

Fund	Expected return	Expected standard deviation
Equity Fund	8%	16%
Bond Fund	3%	5%

The correlation coefficient between the fund returns is 0.10

Draw the capital allocation line (CAL) of your portfolio on an expected return-standard deviation diagram. What is the slope of the CAL?  

Answer 1

E(ri) Expected return of portfolio

s(p) standard deviation of portfolio

E(Rp) = w1*r1 + w2*r2

w1: weightage of equity fund

r1: expected return on equity fund = 8%

w2: weightage of corporate bond fund

r2: expected return on corporate fund = 3%

w1+ w2 = 100%

s(p)^2 = (w1*s1)^2 + (w2*s2)^2 + 2*w1*w2*p*s1*s2

s(p): standard deviation of portfolio

s1: standard deviation of equity fund = 16%

s2: standard deviation of corporate bond fund = 5%

p: correlation between two stocks = 0.1

Rf: risk free rate = 1.25%