Q11

(i) The annual risk free rate Of return is 5% and the expected returnon the market is 12%. The standard deviation of the market is 15% per annum You decide to invest in a portfolio that combines the risk-free asset and the market, with borrowing or lending permitted at the risk-free rate (i.e. a portfolio on the Capital Market Line. You are happy to accept a standard deviation of 20%. but no more.

Considering the limit on standard deviation, what is the maximum possible expected return of your combined portfolio? What would be the weight of the risk-free asset & the market in this portfolio? What is the beta of this portfolio?

(ii) Your parents want to invest their entire life savings, in a portfolio that achieves diversification by equal-weighting across three different stocks, instead of buying a market index fund Should your parents worry about the portfolio's systematic (market) risk OR its firm-specific(idiosyncratic) risk. OR both? Explain our answer concisely.