Question 4

1. You currently have all your funds invested in a portfolio of shares of Polycorp (PLC).The shares have an expected return of 11%pa and a standard deviation of 20%pa.You are offered the opportunity to invest in two funds managed by the Rearguard Portfolio Management Company. One is a Bond Fund that has an expected return of 4%pa and a standard deviation of 6%pa. The other fund is one that tracks the market index and has an expected return of 16%pa and a standard deviation of 23%pa. The correlation between the index fund and the bond fund is 0.1. Construct a portfolio of the Index and Bond funds that gives the same expected return as a portfolio of Polycorp shares. What is the composition and standard deviation of this portfolio? Use this example to comment on the benefits of diversification.