You currently own shares in Bentel Mutual Fund (BMF). Your broker calls and recommends buying shares in a small-capitalization fund managed by Wolly Investment Group (WIG). Your broker says that this fund will provide significant diversification benefits for your existing holdings. She gives you the following statistics based on the performance of the two funds over the last year.

Portfolio E(Return) Std. Dev.

Bentel Mutual Fund 20%12%

Wolly Investment Grp. 14%11%

a)Assume you can earn an average annual yield of 8% on a risk-free security. Which of these funds would be the optimal fund to combine with the risk-free security? Why? (6 Marks)

b) Using the fund you selected in part (a), how much portfolio weights in the fund and the risk-free security would be required to earn a target return of 22%? Describe this position. (7 Marks)

c) Assume the covariance between the Bentel and Wolly funds is 0.00154. What would have been your average return and standard deviation over the last year if you placed 60% of your investment in Bentel and 40% of your investment in Wolly? (7 Marks)