Suppose you are considering investment in a stock fund and a bond fund. The following table summarizes the risk and return characteristics of the above two funds.
Fund Expected return and Standard deviation
Stock 13% 18%
Bond 6% 9%
The correlation of rates of return between the stock fund and the bond fund is -0.1 and the risk-free return is 2%.
i. Using the above information, determine the expected return and standard deviation of the optimal risky portfolio consisting of the stock fund and the bond fund.
ii. The article states that ‘borrowed money can make even an optimally diversified — and theoretically ‘safe’ — portfolio risky’. Assuming the margin debts will not be ‘called’, demonstrate whether the above statement is correct if you borrow 50% of your fund at the risk-free rate and invest in the optimal risky portfolio in(b)(i).
iii. Messrs Jacobs and Levy argue that modern portfolio theory needs urgent updating to account for the devastation that can be wrought by borrowed money. Briefly explain whether you agree with them.