The following questions assume there are three risky asset classes in the econom
ID: 2799032 • Letter: T
Question
The following questions assume there are three risky asset classes in the economy. Market Capitalization ($ trillion) 8 Asset Small Cap Equity Large Cap Equity Corporate & Govt Bonds Beta 1.9 1.4 0.4 Volati 20 15 9 12 20 2. What are the weights and beta of the market portfolio? What is the expected return of Large Cap Equity if the market portfolio has an expected return of 10% and the risk free rate is 1%? 3. The following is the correlation matrix for the three risky assets. Small Cap Equity Large Cap Equity Corporate & Govt Bonds 0.2 0.4 Small Cap Equity 0.6 Large Cap Equity 0.6 Corporate & Govt Bonds 0.2 0.4 What is the expected return and volatility of the portfolio that is 60% Large Cap Equity an 40% Corporate and Govt Bonds? 4.Explanation / Answer
Answering only 4th as asked.
Expected return of large cap using CAPM formula
= Rf + beta*(Rm-Rf)
= 1 + 1.4*(10-1)
= 13.6%
Expected return on corporate and government bonds =
= 1 + 0.4*(10-1) = 4.6%
So, expected return of portfolio = 0.6*13.6+0.4*4.6 = 10%
Volatility = ((0.6^2)*(15^2)+(0.4^2)*(9^2) + 2*0.6*0.4*15*9*0.4)^0.5
= 10.95
Where 0.6 and 0.4 are respective weights, 15 and 9 are respective volatility, and 0.4 is correlation between large cap and government bonds.
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