Consider a risky portfolio consisting of a bond fund with expected return E(rB) equal to 7% with a standard deviation σB of 10%, as well as a stock fund with expected return E(rS) equal to 11% with a standard deviation σS of 20%. The correlation coefficient between the returns on the bond and stock funds, ρBS, is equal to .2 and the risk-free rate is 3%.
(a) Draw the optimal CAL and calculate its Sharpe ratio.
(b) Calculate the investment proportions in the bond fund, the stock fund, and the risk-free asset for investor with risk aversion, A, equal to 5.
(c) What is the answer to (b) above if our investor is less risk averse; that is, her risk aversion, A, is now equal to 3.