Percival Hygiene has $10 million invested in long-term corporate bonds. This bond portfolio’s expected annual rate of return is 9%, and the annual standard deviation is 10%.
Amanda Reckonwith, Percival’s financial adviser, recommends that Percival consider investing in an index fund that closely tracks the Standard&Poor’s 500 index. The index has an expected return of 14%, and its standard deviation is 16%.
a. Suppose Percival puts all his money in a combination of the index fund and Treasury bills. Can he thereby improve his expected rate of return without changing the risk of his portfolio? The Treasury bill yield is 6%.
b. Could Percival do even better by investing equal amounts in the corporate bond portfolio and the index fund? The correlation between the bond portfolio and the index fund is +.1.
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