Assume the following information pertains to two mutual funds FUND Expected Retu

Question

Assume the following information pertains to two mutual funds

FUND

Expected Return

Standard Deviation of Return

Debt

6%

12%

Equity

12%

20%

Assume that the correlation between debt and equity is 30%. Recall that by definition, cov(a,b) = corr(a,b)sasb

a. (5) What is the expected return of a portfolio of 70%Debt and 30%Equity?

b. (10) What is the standard deviation of this portfolio of 70%Debt and 30% Equity? (Show your work for credit)

c. (5) Would all risk averse investors prefer the portfolio of 70%Debt and 30%Equity to a portfolio of 100% Debt? (Assume this question pertains to the complete portfolio of the investor). Explain your answer carefully. CREDIT is 100% on the BASIS OF YOUR EXPLANATION.

FUND

Expected Return

Standard Deviation of Return

Debt

6%

12%

Equity

12%

20%

Explanation / Answer

Expected return=.7×.06+.3×.12=7.8%

Covariance=.3×.12×.2=.0072

Standard deviation of portfolio=(.7^2×.12^2+.3^2×.2^2+2×.7×.3×.0072)^2=11.69%

Since standard deviation of portfolio is less than that of only bond.So all risk averse investors prefer the portfolio.

Thank you .

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