You are an investment 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 1.25%pa. The data on the risky funds are as follows:

Fund	Expected return	Expected standard deviation
Equity Fund	8%	16%
Bond Fund	3%	5%

The correlation coefficient between the fund returns is 0.10

a You 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)

b Draw 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)

c Your 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 8%.

• 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 portfolios CAL. Show your working.

(3 marks)

d Your clients 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 clients optimized portfolio? Show your working.

(3 marks)