Consider the case of 2 risky assets. Asset 1 has an expected return of 18.0% and a standard deviation of 22.0%. Asset 2 has an expected return of 8.0% and a standard deviation of 10.0%. The correlation coefficient for the two assets is 0.30. The return on the risk-free asset is 4.5%.
1. What is the covariance of Assets 1 and 2?
2. What are the expected return and standard deviation of a portfolio composed of 70% Asset 1 and 30% Asset 2? Refer to this portfolio as the “(70,30) portfolio.”
3. What are the expected return and standard deviation from allocating our wealth 25% to the risk-free asset and 75% to the (70,30) portfolio in Step #2?
4. What is the slope of the line formed by all possible combinations of the risk-free asset and the (70,30) portfolio?
5. What portfolio (selected from all the possible combinations of Asset 1 and 2) forms the best possible Capital Allocation Line? The correct answer will define the portfolio according to the weights, e.g. (w1,w2) = (70,30).
6. What is the slope of the Capital Market Line (CML)?
7. What are the expected return and standard deviation of a portfolio that invests -20% in the risk-free asset and the remainder of the portfolio in the optimal portfolio found in Step #5?