Question

11-38. In addition to risk-free securities, you are currently invested in the Tanglewood Fund, a broad- based fund of stocks and other securities with an expected return of 12% and a volatility of 25%e Currently the risk-free rate of interest is 4%. Your broker suggests that you add a venture capital fund to your current portfolio. The venture capital fund has an expected return of 20%, a volatility of 80%, and a correlation of 0.2 with the Tanglewood Fund. Calculate the required return and use it to decide whether you should add the venture capital fund to your portfolio. 0.2 y8% 12% -4%) = 9-127. 25% 4+ t elECRT-f) EOR)- ECPve)-rf 4Y, + 0.8xo.2 O.25 P(RT) Corr SDCRvc) 9.(29%0 &% (6% iuon Your current portfolio, has an

how to solve this question? I want to know whether my solution is correct.

<My solution>

the 9.12% is the required return for venture capital fund in the current portfolio of Tanglewood,

and the expected return of venture capital fund is 20%, so

20% > 9.12% makes it conclude that we should add more venture capital funds in the portfolio.

Answer 1

I think here we should Sharpe ratio to whether we property compensated for the risk we are taking

Sharpe ratio measure how much return generated above risk free for the risk taken (volatility)

For the current portfolio in Tanglewood fund

Expected return = 12% and Volatility (Standard deviation) = 25%

Risk free rate = 4%

Sharpe Ratio = (Expected return - risk free rate) / Standard deviation

Sharpe Ratio = (12% - 4%) / 25%

Sharpe Ratio of Tanglewood fund = 0.32

For the new venture capital fund

Expected return = 20% and Volatility (Standard deviation) = 80%

Suppose we equally add new venture capital fund in our portfolio

Portfolio expected return = 50% * expected return on Tanglewood fund + 50% * expected return of venture capital fund

= 50% * 12% + 50% * 20%

Portfolio expected return = 16%

Portfolio standard deviation = square root of (50%^2 * Tanglewood stand dev.^2 + 50%^2 * Venture capital stand dev.^2 + 2 * 50% * 50% * Tanglewood stand dev. * Venture capital stand dev. * correlation coefficient)

= square root of (50%^2 * 25%^2 + 50%^2 * 80%^2 + 2*50% * 50%*25%*80%*0.2)

Portfolio standard deviation = 44.2%

Sharp Ratio for the portfolio = (16% - 4%) / 44.2%

Sharp Ratio for the portfolio = 0.27

Since the Sharpe ratio for the combined portfolio is 0.27 is lower then Tanglewood fund sharpe ratio of 0.33

We should not invest in new venture capital fund