Question

Investment Portfolio

You are an investment manager for Simple Asset Management, a company that specializes in developing simple investment portfolios consisting of no more than three assets such as stocks, bonds, etc., for investors who like to keep things simple. One of your more popular investments is called the All World Fund and is composed of global stocks with good dividend yields. A client is interested in constructing a portfolio that consists of the All World Fund and the Treasury Index Fund, which consists of U.S. Treasury securities (government bonds).

You calculate a 7.8% expected return on the All World Fund with a return standard deviation (a measure of risk) of 18.90%. The expected return of the Treasury Index Fund is 5.50% with a return standard deviation of 4.6%. To analyze the relationship between the two investments, you also calculate the covariance between the two of –12.4.

Which graph below best represents the expected returns for the following investment allocations?

a.

b.

c.

d.

Answer 1

OPTION C

Answer 2

w2 8.00% Investment Allocation Treasury fund index weight All World Fund w1 100% 0% 75% 25% 50% 50% 25% 75% 100% Expected return (w1*R1+w2*R2) 5.500% 6.075% 6.650% 7.225% 7.800% 6.00% 0% 4.00% Expected return Treasury fund All world fund 5.50% 7.80% Standard deviation 4.60% 18.90% 2.00% 1 2 Covariance = -12.4