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An investor is uncertain about how much to invest in two risky assets. The first asset (equity) yields an expected return of 10% and has a standard deviation equal to 8%. The second asset (debt) yields an expected return of 5% and has a standard deviation of 7%. The correlation coefficient between the returns is 0.1.
a. Compute the expected return and standard deviation of the following portfolios:
Portfolio
Percentage in equity
Percentage in debt
1
90
10
2
50
3
Equity
Debt
R
0.1
0.05
SD
0.08
0.07
Var
0.0064
0.0049
% in equity
% in debt
Expected R
0.9
0.095
0.005
0.073
0.5
0.075
0.003
0.056
0.055
0.004
0.064
b. In the mean-standard deviation space, sketch the set of portfolios composed of debt and equity and identify portfolios 1, 2, and 3 on your graph.
c. Would a rational risk-averse investor ever choose portfolio 3? Would a rational risk-averse investor ever choose portfolio 1?
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