5. Your company offers three funds to its employees for their pensions: a money-market fund, an S&P 500 index fund and a new-economy equity fund. You need to form a portfolio from these funds for your own pension investments. The money-market fund is invested in 3-month Treasury bills, now with a risk-free return of 1.5% per annum. The index fund gives a premium of 8% and a standard deviation of 20% per annum. The new-economy funds return can be described by the following equation:

rt rF = + (rM t rF ) + et

wherert and rMt are the fund and market returns, rF is the risk-free return, is a constant, and et is the part of the funds returns not explained by the market. The performance of the fund over the last 60 months gives

= 0.0

= 1.2

R2 = 0.75 (proportion of the variance of the funds return explained by the market return).

(a) Compute the expected return of the new-economy fund using CAPM. Use reasonable estimates for the market return and the risk-free return.

(b) If CAPM holds, what is the optimal portfolio to achieve an expected return of 8% per annum.

(c) If instead, the estimate of is 0.0050 (0.5% per month) with a standard error of 0.0015. Without doing any calculations, discuss how this may affect your portfolio