Question

An investor is faced with two risky asset portfolios (each of which is highly diversified within its asset class) - an equity fund and a bond fund. The investor is aware that asset returns are not always normally distributed, but is nonetheless prepared to use the normal distribution as a tool for the estimation of approximate portfolio risks and expected returns. The equity fund has a forecast expected return of +11 % pa over the time horizon of 12 months, and the investor is more than 99.7% sure that the range of outcomes will lie between a worst case scenario of about-34%pa and a best case scenario of approximately+56%pa. The bond fund has a forecast expected return over the time horizon of +4% pa, and an interval between worst and best case scenarios of -8%pa to +16%pa. The covariance between the equity fund and the bond fund is believed to be approximately +6. There is a perfectly competitive banking system where interest rate margins for customers such as this investor have been driven down to zero. The current interest rate on 12 month deposits is 1%pa Suppose the investor wishes to maintain the balanced risky asset portfolio of shares and bonds, but has a target rate of return of 10.75% pa on her combined portfolio. How could the investor raise the expected return to 10.75%pa? What weights would she have for the equity fund, the bond fund and the risk-free asset in her combined portfolio? What level of risk would be involved? (15%) 1. 2. What would be the risk and expected return of a portfolio consisting entirely of the equity and bond fund, but with weights chosen to minimise the portfolio variance? (15%)

Answer 1

Answer The Given infomaton Expected Rehan of Eguity Rnd-11 Eupouched Retuin of Bond 49. weight of hof equilty and bouak fund sos Epeated Refun of Portfollo weight of SecuExpected Rehan of ecuity ) + (weight of Security Expected Rehain of Serite S t2 75 In Z tuble HtRe Value is. rs 56-11- 17

dandand deviation:ls.10 → Tp we assume Suret in bonds also to le ,, . 4941 standard devia hon bond would be 44 -) por lo-75% of expected Rhum Tre weiah- of risky asset portfolio loan Should be ta ken Prom riske free astels hence The weight of eui Minimum weight to be allocated-to egui fands and s to eba maimum wel