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1. Consider that 2 investment funds exist. ABC Fund(invested in 50% normal stock and 50% risky bonds) and 123 Fund(invested in 25% High risk stock and 75% normal bonds).

Assume you have the following historical data of annual returns:

Return S.D.

Normal Stock 8% 20%

Risky Bonds 10% 35%

High Risk Stock 14% 40%

Normal Bonds 6% 10%

A. If Normal Stock and Risky Bonds have a correlation coefficient of 0.4 and High Risk Stock and Normal Bonds have correlation coefficient of 0 .2. Find the expected return and standard deviation of each Fund.

B. Find the optimal risky portfolio if you could only use these two funds; assume the two funds have a correlation coefficient of 0.3. (To use excel and create 101 different combination of the two funds, where allocation or "w" for fund ABC is 0, then.01, then .02 and so forth until w=1. For each of these points calculate the Sharpe ratio. Graph these results with returns on the y axis and S.D on the x axis. Remember to report the return and standard deviation of the optimal risky portfolio.) The risk free rate is .02. (Turn in graph)

C. No need to show any work, just explain you reasoning. If the correlation coefficient was .4 would that lead to a better or a worse optimal risky portfolio? If another fund was added would this make things better or worse?

D. For what risk level is the optimal risky portfolio the same as their optimal complete portfolio?

E. If someone has a 3 or a 5 level of risk aversion what is there optimal complete portfolio? Why is the optimal risky portfolio optimal for everyone?

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