Assume the market is formed of only two securities (a bond fund and a stock fund). Use the following numbers in Excel:

E( r ) ( r ) Corr(B,S)

Bonds (B) 0.13 0.23

Stocks (S) 0.22 0.32 0.15

Take the following steps:

1. Consider alternative two-asset portfolios formed by varying the weights for the two funds provided above. That is, start with a portfolio that has 0% in the stock fund and 100% in the bond fund and calculate E(rP) and s P . Repeat the exercise by increment of 2% for the weight of the stock fund (i.e. recalculate E(rP) and s P for a portfolio that has 2% in stocks, then 4%, then 6% etc). Note that as long as you know the weight of the stock fund in the portfolio of two assets, the weight of the bond fund is also known (the two weights should add to 1).

2. Graph these data points the resulting figure should be your investment opportunity set (your graph should be similar to Figure 6.3 in your textbook). What is your efficient frontier? Why?

3. The first question to ask at this point is what is the minimum variance portfolio? Is it among the ones you found in step 1 (this would be very unlikely)? How can you find the minimum variance portfolio? Determine its return and standard deviation. What are the weights for stocks and bonds in this portfolio? (hint: read example 6.2 and footnote 1 on page 156 in your textbook)

4. Repeat steps 1 through 3 when the correlation between stocks is 0, and then with a correlation of -.9. How and why does the shape of your investment opportunity set change? What is the new minimum variance portfolio in each one of these cases? Explain!

5. What is the optimal portfolio for each one of the frontiers (i.e. the portfolio that optimizes your Sharpe ratio)? Assume that your particular degree of risk aversion dictates that you invest 35% of your wealth in the risk free asset and 65% in the optimum portfolio. Consider a risk free rate of 2%. Can you describe your overall allocation for each one of the three cases above?

Report should include:

- Your Excel Worksheet with your numbers (you will have three of them because of the three different correlation numbers). Identify the formulas you used for calculating E(rP) and s P .

- Graph each of the investment opportunity sets separately and then put them together on the same graph.

- Make sure your graphs identify the minimum variance portfolios. Describe the formulas you used for obtaining them.

- Discuss each one of the questions identified in the project description.