You already have a well-diversified portfolio of domestic assets. You are considering reallocating some of the money in your domestic portfolio to a global equity fund that invests in foreign firms in Europe and Asia. You collect 10 years of annual data on the returns of your domestic portfolio and the global equity fund you are thinking about investing in. You then calculate mean returns, standard deviations and a correlation coefficient for the two funds. The result of this analysis is listed below. You expect that the return behavior in the past is representative of the type of behavior you can expect for these funds over the next few years.
Produce a spreadsheet that lists the expected return and the standard deviation of a risky portfolio of the domestic and global funds varying the percent in the domestic fund from 0% to 100% in steps of 1%.
You can invest in U.S. Treasury bill that yield 2 percent annually. If you reallocate some of the money in your domestic fund to the global fund, what is the best risky portfolio of the two funds, where the risky portfolio is the portfolio of only the domestic and global fund (i.e., it does not include the risk-free T-bill)? That is, what percent of the money you chose to put at risk do you want in the domestic fund and what percent do you want in the global fund?
What are the characteristics of this optimal portfolio of domestic and global funds? That is, what is the new portfolio’s expected return and standard deviation? How does this compare to these characteristics for your old solely domestic portfolio?
How much will you be able to improve the return per unit risk (i.e., the Sharpe Ratio) you can create for yourself by investing in the one-year treasury bills and a new portfolio of both domestic and global funds?
Annual returns
Domestic Fund Global Fund
Expected Return: .10 .08
Standard deviation: .20 .35
Correlation Coefficient: PD,G=.1
Risk-free rate = Rf = .02