You are a pension fund manager considering two mutual funds. The first is an equity fund and the second is a long-term corporate bond fund. It is possible to borrow or to lend limitless sums safely at 2%pa. The data on the risky funds are as follows:

Fund Expected return Expected standard deviation

Equity Fund 12% 10%

Bond Fund 4%. 4%

The correlation coefficient between the fund returns is 0.25

aYou form a risky portfolio P that is equally weighted between the bond fund and the equity fund. Calculate the forecast expected return and the estimated risk of your portfolio.Show your working.

(2 marks)

bDraw the capital allocation line (CAL) of your portfolio on an expected return-standard deviation diagram. What is the slope of the CAL?Show your working.

(2 marks)

cYour client wants to invest a proportion of his total investment budget in your risky portfolio identified in part (a) to provide an expected rate of return on his complete portfolio equal to 12%.

• What proportion should he invest in the risky portfolio and how should this be funded?
• What is the risk of his combined portfolio?
• Mark this portfolio onto your portfolio's CAL.Show your working.

(3 marks)

dYour client's degree of risk aversion is A= 6.

• What proportion, y, of his total investment should be invested in your risky portfolio?
• What is the expected return and standard deviation of the rate of return on your client's optimized portfolio?Show your working.

(3 marks)