Finance and Accounting

Question 1 [20 marks]

You are a fund manager who is considering three mutual funds: a fund of equities
E; a fund of long term corporate debt D; and a fund of safe short-term government
debt F which yields a rate of return of 5%.
The probability distributions for the two risky funds are given in the table

Expected Return E[r] Standard Deviation, ?
Equity Fund (E)  14%  26%
Debt Fund (D)  9% 14%
The correlation between the risky funds is ?
E,D
=  0.2.

Your investment analyst has determined that the optimal risky portfolio of the
two risky funds has the expected rate of return of 11.1% and standard deviation
of 14.8%.

a)   Determine the minimum-variance portfolio of the two risky funds as given by
the weights  wD
and  wE
of your investment into  funds D and E respectively.
Determine the expected rate of return  and the standard deviation of the
minimum-variance portfolio. Show all relevant calculations.  [7 Marks]

b)   Present graphically in the E[r]-? plane the portfolio opportunity set as given
by the two risky funds E and D. Indicate all relevant reference points.

Without doing any calculations, demonstrate graphically in the same E[r]- ?
plane how the portfolio opportunity set  would change (relative to its current
2
position) if the correlation between the risky funds D and E takes value:  ?
E,D

= – 0.2. Provide an explanation in no more than 150 words.
1
[8 marks]

c)   Your client Jin Li wishes to obtain 17% return on her investment portfolio.
How would you advise your client to allocate her capital among the available
portfolios E, D and F? What will be the standard deviation of your client’s
portfolio? Present all relevant calculations.  [5 marks]

Question 2 [10 marks]

Your clients Peter and Jane  have coefficients of risk aversion: A=1.5 (Peter)
and A=3.0 (Jane).

(a) Indicate briefly how would you charact erise each of these investors’
attitude to risk: (i) risk-loving, (ii) risk-neutr al or (iii) risk-averse?  [2
Marks]

(b)  Without any calculations, indicate which of the indifference curves
depicted below: C1 or C2  is likely to belong to Ja ne?  Explain your answer
carefully in no more than 200 words.  [8 Marks]